L Pch12


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L Pch12

  1. 1. Investments Chapter 12: Efficient Markets: Theory and Evidence
  2. 2. Definition: An Efficient Market <ul><li>A well-functioning financial market in which prices reflect all relevant information. </li></ul><ul><li>In an efficient market investors cannot earn abnormal returns by finding buying or selling opportunities. </li></ul><ul><ul><ul><li>Abnormal returns : Rates of return that are above what an investor would be expected to earn given the level of risk taken. </li></ul></ul></ul>
  3. 3. The Continuum of Information Relevant to Price Determination <ul><li>Information incorporated in asset prices and therefore not useful in earning abnormal returns: </li></ul>Exhibit 12.1 Continuum of appropriate information sets Source: From Introduction to Investments , 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.
  4. 4. Definition: Weak form <ul><li>When today’s stock prices reflect all information about historical prices. </li></ul><ul><li>In the weak form investors cannot earn abnormal returns by analyzing historical prices, because price changes seem to follow a random walk. </li></ul><ul><ul><ul><li>If cumulative abnormal returns are statistically significant from the expected ones, the market is not efficient (in weak form) and technical analysis helps! </li></ul></ul></ul><ul><ul><ul><li>From 21 different studies, almost half of them support the weak form. </li></ul></ul></ul>
  5. 5. Definition: Semi-Strong form <ul><li>When today’s stock prices reflect, in addition to historical prices, all relevant publicly available information. </li></ul><ul><li>Public information includes financial statements, the stock’s beta, announcements on extra dividends or splits, a new crisis, a new product etc. </li></ul><ul><ul><ul><li>If fundamental analysis done by analysts/researchers leads to statistically significant higher cumulative abnormal returns, the market is not efficient (in the semi-strong form)! </li></ul></ul></ul><ul><ul><ul><li>From 14 different studies, 8 of them reject the semi-strong form, because, for instance, extra earnings continue for rather long time, after the publication. </li></ul></ul></ul>
  6. 6. Definition: Strong form <ul><li>When today’s stock prices reflect, in addition to historical prices and to all relevant publicly available information, even the privately available information. </li></ul><ul><li>Notice that insiders who trade on their private information run the risk of big fines and many years in jail! </li></ul><ul><ul><ul><li>If insiders make higher abnormal returns, the market is not efficient (in the strong form)! </li></ul></ul></ul><ul><ul><ul><li>From 11 different studies, 7 of them reject the strong form, because, for instance, extra returns are observed some days before the publication. </li></ul></ul></ul>
  7. 7. Passive vs. Active Portfolio Management <ul><li>Passive Investment Strategies </li></ul><ul><li> No re-balancing of investment portfolios (e.g. Index Funds). </li></ul><ul><li>Active Investment Strategies </li></ul><ul><li> Active re-balancing of investment portfolios. </li></ul><ul><li>If the market is efficient (in the semi-strong form) you can’t benefit from active investment strategies. The prices are just right! Thus, in that case, only the passive management strategy is relevant. </li></ul>
  8. 8. Anomalies <ul><li>Events that are not anticipated and that offer investors a chance to earn abnormal returns. </li></ul><ul><li>Two primary techniques to test whether markets are weak-form-efficient: </li></ul><ul><li>1. Analysis of technical trading rules for abnormal rates of return. </li></ul><ul><li>2. Statistical tests on historical data to locate significant patterns. </li></ul>
  9. 9. Anomalies <ul><li>Four categories of anomalies: </li></ul><ul><li>Firm anomalies. </li></ul><ul><li>Accounting anomalies. </li></ul><ul><li>Calendar anomalies. </li></ul><ul><li>Event anomalies. </li></ul>
  10. 10. Behavioural Finance <ul><li>Traditional investment theories seem unable to explain market inefficiencies and market anomalies. </li></ul><ul><li>Behavioural finance assumes that the psychology of decision-making under uncertainty may explain these phenomena. </li></ul>
  11. 11. Arguments of Behavioural Finance <ul><li>Errors of Judgement </li></ul><ul><li>The decision-maker consistently over- or underestimates the true probability of change events. </li></ul><ul><li>Errors of Preference </li></ul><ul><li>The decision-maker systematically deviates from the expected utility criterion: he or she makes mistakes in assigning values to future outcomes of change events. </li></ul>
  12. 12. Critics of Behavioural Finance <ul><li>Main argument: (Fama, 1991) </li></ul><ul><li>‘ market inefficiency per se is not testable’ </li></ul><ul><li>Reason : Market inefficiency must be tested jointly with asset-pricing models that predict the ‘normal’ rates of return. We are not certain if the CAPM is correct (or the betas are correct) to be able to test if deviations are due to “market inefficiency”. (Or, you might be right for the wrong reasons and wrong for the right reasons) </li></ul>