What is an efficient market? - ANS-In an efficient market, security prices adjust rapidly to the arrival of new
information, therefore current prices of ... [Show More] securities reflect all information about the security.
An efficient market is a market where information is incorporated into the security's price instantaneously.
Investors buying securities in an efficient market should expect to obtain an equilibrium rate of return.
Efficient market - Alternative definition - ANS-If a market is efficient, changes in security prices occur
randomly - or more technically, there is no systematic correlation between one movement and subsequent
ones.
-Since stock prices only respond to new information, which by definition arrives randomly, stock prices are
said to follow a random walk.
-The movements of stock prices from day to day do not reflect any pattern.
Condition for efficient markets - ANS--Large number of rational, profit-maximising investors actively
participate in the market.
-Once information becomes available, market participants analyse it and react quickly and fully to new
information.
-Competition assures prices reflect information.
Efficient market hypothesis (EMH) - ANS-EMH is an empirical hypothesis. EMH is the theory about whether
securities' prices reflect the right information under various circumstances. Three levels of efficiency
according to the information sets:
-Weak-form efficiency (past information)
-Semistrong-form efficiency (all publicly available information)
-Strong-form efficiency (all relevant information)
Weak-form efficiency - ANS--Security prices reflect all past information, including the historical sequence of
prices, trading volume data, and other market-generated information.
-This implies that past rates of return and other market data should have no relationship with future rates of
return.
-Technical analysis that attempts to find patterns in stock prices (chartist) to make profits would be of little
use.
Semi-strong form efficiency - ANS--Security prices reflect all publicly available information, including
accounting statements, economic activities, such as change of GDP, interest rate and inflation rate, etc.
-Investors cannot act on newly released information to earn abnormal returns, which implies that decisions
made on new information after it is public should not lead to above average risk-adjusted profits from those
transactions.
-Fundamental analysis, which uses economic and accounting information to predict stock prices.
Strong-form efficiency - ANS--Security prices reflect all public, as well as private information that is
available only to company insiders.
-This version of the hypothesis assumes perfect markets. It implies that no group of investors should be
able to consistently derive above-average risk-adjusted rates of return.
-All analysts are redundant, or no body can beat the market.
Tests for EMH? - ANS-These forms fall into three broad categories thereafter:
-Predictability: are changes in stock prices random?
-Event studies: do markets quickly and accurately respond to new information?
-Inside information: the record of professionally managed investment firms.
How well do past returns predict future returns? - ANS-If prices follow a random walk, there is no pattern to
follow - price changes over time are independent. So, one way to test for weak form efficiency is to test
statistically the independence of stock price movement. The empirical evidence largely supports the weak
form efficiency.
How quickly do security prices reflect public information announcements? - ANS-Most tests utilise event
studies - empirical analysis of stock price behaviour surrounding a particular event. The studies generally
support the view that the market is semi-strong form efficient.
Do any investors have private information that is not fully reflected in market prices? - ANS-Empirical
studies focus on the performance of professional fund managers who have access to non public
information. There is evidence in favour of existence of superior analysts who apparently possess private
information. Therefore insider trading is abnormally profitable.
Empirical challenges (Calendar effect) - ANS--Day of the week effect (weekend effect): the stock market
tends to fall on Monday's and then rise the rest of the week.
-The holiday effect: returns on the day before the holiday weekends was 9 to 13 times larger than the
average daily return.
-The January effect: the average stock's return in January is more than five times larger than the mean
monthly return obtained by averaging over all 12 months of the year.
-Apparent profit may not be achievable because of transaction costs.
Empirical challenges (The size effect - small vs large) - ANS-The size is measured by total market value.
-Empirical studies show that the stocks issued by small companies earned higher rates of return, on
average, than stocks issued by large companies.
-Even after accounting for the higher risk in small stocks.
-The small firm effect is not stable from year to year.
Empirical challenges (Value effect) - ANS--Value firms can be denoted by those having low P/E ratio.
-Empirical studies show that returns on low P/E shares.
-These evidence suggests that value firms out perform growth firms.
Empirical challenges (stock market crashes and bubbles) - ANS-Dow Jones Industrial index fell by 23% on
Monday, 19th October 1987 following a weekend during which little surprising information was released.
A drop of magnitude for no apparent reason is inconsistent with market efficiency.
Implications of EMH - ANS-The EMH has implications for the capital market (investors).
-No abnormal return can be systematically made in an efficient market.
-Arbitrage removes inefficiency
-Block trading will not affect prices [Show Less]
