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FINC3017 Investments and Portfolio Management Tutorial 7 Solutions Market Efficiency

1.

Outline the key events leading up to the dot.com crisis that occurred in the United States in 2000. What arguments have been put forward as an explanation for this event?

During the 1990s, the world was witnessing a major technological change with the advent of the internet. Some commentators at the time argued that the world of global commerce was about to undergo a fundamental shift. By the end of the 1990s, some technology stocks had appreciated in value not seen since the resource boom almost 30 years earlier even though the businesses were not generating profits or positive cash flow. Then, through 199899, speculation emerged that many computer systems would not copy with the date transition to the 21st century. Further, declining economic conditions, combined with a growing impatience of firms that continued to push back dates of sales, saw the market sentiment turn against the dot.com industry. Prices fell heavily in 2000 and continued during 2001, leaving stock prices back where they were several years before. The declining economic conditions also led to many bankruptcies among dot.com companies. The causes of the dot.com crisis are still a key topic of debate. Some commentators argue that the market simply become over-enthusiastic and moved away from fundamentals. Other commentators argue that the uncertainty of the technology at the time led to valuation that was inflated with the benefit of hindsight, but nonetheless justified at the time because of the upside potential. 2. Fund managers use large amounts of resources to undertake research into the stock market. a) Why do you think fund managers devote resources to research? b) If this type of activity was suddenly stopped because of a widely held belief in market efficiency, what would be the implications? a) Fund managers undertake research because they may believe the market to be inefficient. The results of their research may lead to profitable opportunities. As fund managers are rewarded partly on the basis of performance, there is a clear incentive to search for profitable opportunities. Moreover, even if a fund manager did believe in market efficiency, they might need to be seen by their clients as believers in inefficiency. Hence, in order to maintain confidence with their investor base, the fund manager undertakes research. Further, research activity may be a form of insurance to a fund manager. That is, the fund manager may not have a deep conviction one way or another in relation to the efficiency debate but undertakes research to assure themselves and to make sure that any profitable opportunities are not missed. Note that if fund managers and other investors do not take perceived profits as they arise, then perceptions of inefficiency would remain. b) Arguably, research is in action which makes the market efficient. Believers of market efficiency argue that it is the existence of believers in market inefficiency that keeps the market efficient. The irony is that investors who seek to exploit market inefficiencies by their own actions ensure that any inefficiency is eliminated. Competition among investors trading on perceived inefficiencies helps to maintain efficient prices. Research by fund managers may fit within this argument. That is, it is the research activity undertaken by funds which helps maintain an efficient market. If this research was stopped, inefficiencies may prevail.

3.

Respond to each of the following comments a) If stock prices follow a random walk, then capital markets are little different from a casino. b) A good part of a companys future prospects are predictable. Given this fact, stock prices cant possibly follow a random walk. c) If markets are efficient, you might as well select your portfolio by throwing darts at the stock listings in the Australian Financial Review. a) Though stock prices follow a random walk and intraday price changes do appear to be a random walk, over the long run there is compensation for bearing market risk and for the time value of money. Investing differs from a casino in that in the longrun, an investor is compensated for these risks, while a player at a casino faces less than fair-game odds. b) In an efficient market, any predictable future prospects of a company have already been priced into the current value of the stock. Thus, a stock share price can still follow a random walk. c) While the random nature of dart board selection seems to follow naturally from efficient markets, the role of rational portfolio management still exists. It exists to ensure a well-diversified portfolio, to assess the risk-tolerance of the investor and to take into account tax code issues.

4.

In a recently closely contested lawsuit, Apex sued Bpex for patent infringement. The jury came back to day with its decision. The rate of return on Apex was 3.1%. The rate of return on Bpex was 2.5%. The market today responded to very encouraging news about the unemployment rate, and rm was 3%. The historical relationship between returns on these stocks and the market portfolio has been estimated from index model regressions as: Apex: ra = 0.2% + 1.4rm Bpex: ra = -0.1% + 0.6rm On the basis of this data, which company do you think won the lawsuit?

Given market performance, predicted returns on the two stocks would be: Apex: 0.2% + (1.4 3%) = 4.4% Bpex: 0.1% + (0.6 3%) = 1.7% Apex underperformed this prediction; Bpex outperformed the prediction. We conclude that Bpex won the lawsuit.

5.

Despite substantial research into market efficiency, there is no clear consensus. In part, the problem of the joint test restricts the power of the research results. Explain what is meant by the joint test problem and its significance.

Any test of market efficiency necessarily compares returns against some benchmark. For instance, an inefficient market may be one in which excess returns are persistently observed for a particular trading strategy. But how do we define excess returns? A benchmark for the expected return is required before we can measure excess returns. One possible benchmark is a formal asset pricing model, such as the CAPM. But the use of the CAPM as the benchmark implies that the model is appropriate. Hence, in order to define excess returns to test market efficiency, a model for expected return is first required. Thus, any test of market efficiency is inherently a joint test of market

efficiency and the model of expected return. This problem of the joint test also applies in reverse. Implicit in tests of asset pricing models is the assumption that market prices are set in a rational and efficient manner. Thus, in order to test the asset pricing models, we implicitly assume something about market efficiency. Therefore, we cannot test either market efficiency or an asset pricing model without first assuming that one or other holds. As such, any conclusion about market efficiency must be tempered with the knowledge that the results are based on an implicit assumption about the appropriateness of the return benchmark.

6.

Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the EMH?

Thinly traded stocks will not have a considerable amount of market research performed on the companies they represent. This neglected-firm effect implies a greater degree of uncertainty with respect to smaller companies. Thus positive CAPM alphas among thinly traded stocks do not necessarily violate the efficient market hypothesis since these higher alphas are actually risk premia, not market inefficiencies. 7. Why might the degree of market efficiency differ across various markets? State three reasons why this might occur and explain each reason briefly.

1. Market efficiency depends on information being essentially free and costless to market participants. In the U.S. this is the case to a large extent. The U.S. markets are well developed and professional analysts often follow securities. Information is available on television, in the press, and on the Internet. The opposite may be true in other markets, such as those of developing countries, where there are fewer or no analysts and few market participants with these resources. 2. Accounting disclosure requirements are different across markets. In the U.S. firms must meet SEC requirements to be publicly traded. In other countries the requirements may be different or nonexistent. This has implications about the ease with which analysts can evaluate the company to determine its proper value. 3. Markets for "neglected" stocks may be less efficient than markets for stocks that are heavily followed by analysts. If analysts feel that it is not worthwhile to give their attention to particular stocks then ample information about these stocks will not be readily available to investors.