MARKET EFFICIENCYInformationalty Efficient Market *nfrmation refed n price before one can act~88INg OF se conn in rm "Worn lesa tion “SS informa MARKET EFFICIENCY + An efficient market is “a market in which prices fully reflect all available information” + Reflects collective belief of all investors about future prospects. + Impossible to consistently beat the market (market already knows all information) + only unknown, random information causes changes in stock prices + Market Efficiency: + Operational efficiency: + degree to which the institutional settings and mechanisms improve or hamper trading. + transaction costs are reasonable and fair + Informational/pricing efficiency: + the actual current market price of a share ona day fully, quickly and rationally reflects all information about that security + must be approximately equal to its intrinsic value on that day. + If all conditions are met, capital flows will move to the places where they will be the most effective, providing an optimal risk-reward scenario for investors. + Allocational efficiency occurs when companies get funding for the projects that will be the most profitable- both savers and lenders benefitVeRO) + Price at which asset can be bought or sold + based on supply and demand NY INTRINSIC VALUE + Fundamental value-use fundamental analysis to find value + look at economic conditions and company's health and performance + Based on investor's perception on value with a complete understanding of the Mee Uta Oem Mr oreo knowledge will be willing to pay for + Not known with certainty: requires use of judgement- estimate aMarket value = Intrinsic value Market value < Intrinsic value , Market value > Intrinsic value LaInformationally Efficient Market + Asset prices reflect both past and present information + Asset prices reflect new information quickly and rationally + information reflected in price before one can act onit + Asset prices are not affected by well anticipated information + prices only react to unexpected/surprise information + Consistent superior risk adjusted return is impossibleFactors Contributing to Market Efficiency + Number of market participants + investors + financial analysts + varies across time and countries + higher number of participants imply higher market efficiency + in some countries foreigners cannot trade in their markets- bad for efficiency + Availability of information & Financial disclosure to investors + the more information available to investors, the more the market is efficient + developed markets: plenty of information + emerging markets: less information + OTC trading of securities: less informationFactors Hindering Market Efficiency + Trading costs + sell over valued assets and buy undervalued assets if profit is less than transaction cost? + high trading costs decrease market efficiency + Information acquisition costs + cost of buying research is greater than profit gained in executing recommendation + high information acquisition costs decrease market efficiency + Limits to trading + short selling usually increases market efficiency (prevents assets from being over valued) + limits: inability to borrow stock cheaply- reduces market efficiency + Time to place and order and for it to be executed + higher time implies lower market efficiency » fail to record expected profitPERFECT MARKETS + Aim: To ensure the “best” allocation of scarce capital resources, stock markets should ideally be perfect capital markets + Conditions: + perfect competition + no transaction costs, no restrictions/ regulations on the free market + individuals are rational and do not act on emotions + information is costless and is received simultaneously by all market participants. cannot consistently make zi abnormal returnSea CAN WE HAVE PERFECT NVC oY + Highly utopian + Part of it is achievable and has been implemented + no barriers to entry/exit + rules and regulations established to control price manipulation, insider dealing and to require publication of price sensitive information + Perfect market is not an attainable objective + Efficient market situation can be achieved + given an information set at time t, it is not possible to generate the expectation of abnormal future return by trading at time t on the basis of the information set + one cannot consistently “beat” the market ~e™+ Market Efficiency denotes the “speed at which information is impounded in share prices” + There are three forms of market efficiency namely weak form, semi strong and strong form.WEAK FORM MARKET EFFICIENCY Forms of Market Efficiency + Prices fully reflect all past price and volume data + Investors cannot predict future price movements using technical analysis + Investors cannot beat market by relying on past share price + Fundamental analysis can be beneficial * use current information not yet factored into priceS ~” + Looks at the past price and volume information and movement of a security + Uses this data to predict its future price movements. - TA assumes prices follow predictable trends i Shae oFUNDAMENTAL ANALYSIS + Logical and systematic approach to estimating the future dividends and share price. + Looks at economic factors, known as fundamentals. + Look at financial statements: Balance Sheets, Cash Flow Statements, Income Statements + Estimate intrinsic Value eeeForms of Market Efficiency + SEMI STRONG FORM MARKET EFFICIENCY + Prices fully reflect all past market data and publicly known new information + Investors cannot predict future price movements using technical analysis + Investors cannot use fundamental analysis to generate excess returnForms of Market Efficiency STRONG FORM MARKET EFFICIENCY + prices fully reflect reflect all past information, and current new public or private information + market participant cannot earn excess returns except by chance. + Investors cannot predict future price movements using technical analysis + Investors cannot use fundamental analysis to generate excess return + Even an insider cannot earn an excess returncris TEL) Public TOE en) Weak-form Private eu information Semi-strong-form Strong-form+ Semi strong efficiency implies that weak for efficiency holds but not vice versa + Strong form efficiency implies that both semi strong form and weak for efficiency hold foni ak f the markets are weak form efficient or semi- strong form efficient or strong form efficient will technical analysis be able to consistently predict price hanges?t the markets are weak form efficient or semi strong form efficient or strong form efficient will fundamental analysis be able to consistently predict price changes?it~ If the markets are only weak form efficient? Fundamental analysis CAN predict price changes If the markets are semi-strong or strong form efficient? Fundamental analysis CANNOT predict price changes NSMarket Pricing Anomalies Change in price of asset can't be directly linked to current relevant or new information + Calender Effect anomalies /turn of the year effect + excess return in January (first 5 days of January) + not persistent + firms engage in window dressing: try to increase their returns throughout the year by holding risky assets. Since they report to investors in December, they sell these risky assets and buy back in January + Tax loss selling: sell losses in December and repurchase in January; want to realize loss + Turn of month effect + returns are higher on the last day of the month and on the 1st three days of the next month + Day of the week effect + average Monday return is less than that of the other 4 days of the week + evaluate portfolio on weekend and sell on monday?+ returns on weekends less than returns on weekdays + Holiday effects + return on prior day is higher + Momentum + short term price patterns (inconsistent with weak form market efficiency) + when there are high returns, these tend to continue for a short time + Overreaction effect + investors overreact to the release of unexpected (good or bad) information + good news are followed by price increases + bad news are followed by price decreases + If buy loser portfolio and sell winner portfolio, the loser portfolio outperformed the market and the winner underperformed (winner or loser based on total return over past 5 years) + Size effect + small cap companies outperform large cap companies resp Short mome effect count effcie Rendle & LataCumulative abnormal returns in response to earnings announcements Short term momentum effect that is counter to efficiency. Cumulative Average Excess Return (%) Rendleman, Jones & Latane = -20-10 0 10 20 30 40 50 60 70 80 9 Days from Earnings Announcement‘Testing the 3 forms of market efficiency + hard to believe markets efficient + interest rate surprise from CB * causes sustained movement in stock prices ‘Testing Weak Form Ej Micenes “Vesting Strong Form Efficiency ‘rien -itfigerey huSandurshes Nanda 95) cane nas read. Ue testing Strong Form bifcienes {ec keen ic omatonTesting Weak Form Efficiency + can past share prices be used to reflect future prices? (can technical analysis be used?) + statistical and econometrics tests mostly show that evolution of price from one period to the next is independent + inefficiency in US and UK markets + Kendall (1953): change in stock price random in UKTesting Strong Form Efficiency * can past price and current information predict future prices? + Event studies + find effect of release of new public information on share price * merger and acquisition instantly reflected in price? (increase/decrease depending on whether good news or bad news) * most cases: immediately integrated + if not: investors act on it to make gains + temporary only as prices will move towards fair valueTesting Strong Form Efficiency + Can past, current public and private information be used to predict future stock price? + study investment records/gains generated by professional investors + if cannot consistently make gains? = strong form efficient + if share price=exact share value, professionals cannot make gains+ Efficient: corporate actions rapidly reflected in price + manager decides about firm issues + investors react to decisions through price + Manager: maximize shareholder wealth + Efficient: + investors have access to more information + react to bad newsInformationalty Efficient Market *nfrmation refed n price before one can act