FIN 424 [ABBAS FAISAL ALMOMEN TEL: 33332031]

CH7: Stock Price Behavior and Market Efficiency

Three Economic Forces that Can Lead to Market Efficiency
1. Investors use their information in a rational manner.
• Rational investors do not systematically overvalue or undervalue financial assets.
• If every investor always made perfectly rational investment decisions, it would be difficult, if not
impossible, to earn an excess return.

2. There are independent deviations from rationality.

• Suppose that many investors are irrational, and a company makes an announcement.
• The net effect might be that these investors cancel each other out—so, the irrationality is just noise
that is diversified away and the market could still be efficient (or nearly efficient).
• What is important here is that irrational investors have different beliefs.

3. Arbitrageurs exist.
• Suppose there are many irrational traders and their collective irrationality does not balance out.
• Further suppose there are some well-capitalized, intelligent, and rational investors.
i. This group of traders, called arbitrageurs, look for profit opportunities.
ii. Arbitrage: buying relatively inexpensive stocks and selling relatively expensive stocks.
• If these rational arbitrage traders dominate irrational traders, the market will still be efficient.

Forms of Market Efficiency

 A Weak-form Efficient Market is one in which past prices and volume figures are of no use in
beating the market.
If so, then technical analysis is of little use.
 A Semistrong-form Efficient Market is one in which publicly available information is of no use in
beating the market.
If so, then fundamental analysis is of little use.
 A Strong-form Efficient Market is one in which information of any kind, public or private, is of no
use in beating the market.
If so, then “inside information” is of little use.

Some Implications of Market Efficiency: Does Old Information Help Predict Future Stock Prices?
• Some researchers have been able to show that future returns are partly predictable by past returns.
BUT: there is not enough predictability to earn an excess return.
• Also, trading costs swamp attempts to build a profitable trading system built on past returns.
• Result: buy-and-hold strategies involving broad market indexes are extremely difficult to
outperform.
• Technical Analysis implication: No matter how often a particular stock price path has related to
subsequent stock price changes in the past, there is no assurance that this relationship will occur
again in the future.
FIN 424 [ABBAS FAISAL ALMOMEN TEL: 33332031]

Some Implications of Market Efficiency: Random Walks and Stock Prices

• In fact, considerable research has shown that stock prices change through time as if they are
random.
• That is, stock price increases are about as likely as stock price decreases.
• When there is no discernible pattern to the path that a stock price follows, then the stock’s price
behavior is largely consistent with the notion of a random walk.

How New Information Gets into Stock Prices:

• In its semi-strong form, the EMH states simply that stock prices fully reflect publicly available
information.
• Stock prices change when traders buy and sell shares based on their view of the future prospects
for the stock.
• But, the future prospects for the stock are influenced by unexpected news announcements.
• Prices could adjust to unexpected news in three basic ways:
a) Efficient Market Reaction: The price instantaneously adjusts to the new information.
b) Delayed Reaction: The price partially adjusts to the new information.
c) Overreaction and Correction: The price over-adjusts to the new information, but eventually falls to the
appropriate price.

Informed Trading
• When an investor makes a decision to buy or sell a stock based on publicly available information
and analysis, this investor is said to be an informed trader.
• The information that an informed trader possesses might come from:
 Reading the Wall Street Journal
 Gathering financial information from the Internet
 Talking to other investors

Legal Insider Trading

Some informed traders are also insider traders.
Most public companies also have guidelines that must be followed. For example, it is common for
companies to allow insiders to trade only during certain windows during the year, often sometime after
earnings have been announced.

Who is an “Insider”?
• For the purposes of defining illegal insider trading, an insider is someone who has material non-
public information.
• Such information is both not known to the public and, if it were known, would impact the stock
price.
• A person can be charged with insider trading when he or she acts on such information in an
attempt to make a profit.
FIN 424 [ABBAS FAISAL ALMOMEN TEL: 33332031]

Illegal Insider Trading

• When an illegal insider trade occurs, there is a tipper and a tippee.
o The tipper is the person who has purposely revealed material non-public information.
o The tippee is the person who has knowingly used such information in an attempt to profit.
• It is difficult for the SEC to prove that a trader is truly a tippee.
• It is difficult to keep track of insider information flows and subsequent trades.
• Sometimes, people suspect of insider trading claim that they just “overheard” someone talking.
• Be aware: When you take possession of material non-public information, you become an insider
and are bound to obey insider trading laws.

Anomalies
• We will now present some aspects of stock price behavior that are both baffling and potentially
hard to reconcile with market efficiency.
• Researchers call these market anomalies.
• Three facts to keep in mind about market anomalies.
o First, anomalies generally do not involve many dollars relative to the overall size of the
stock market.
o Second, many anomalies are fleeting and tend to disappear when discovered.
o Finally, anomalies are not easily used as the basis for a trading strategy, because
transaction costs render many of them unprofitable.

MCQ
1. The weak form of the EMH states that ________ must be reflected in the current stock price.
A. all past information including security price and volume data.
B. all publicly available information
C. all information including inside information
D. all costless information

2. The strong form of the EMH states that ________ must be reflected in the current stock price.
A. all security price and volume data
B. all publicly available information
C. all information including inside information.
D. all costless information

3. Random price movements indicate ________.

A. irrational markets
B. that prices cannot equal fundamental values
C. that technical analysis to uncover trends can be quite useful
D. that markets are functioning efficiently.
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4. When the market risk premium rises, stock prices will ________.
A. rise
B. fall.
C. recover
D. have excess volatility

5. If you believe in the __________ form of the EMH, you believe that stock prices reflect all publicly
available information but not information that is available only to insiders.
A. semi-strong.
B. strong
C. weak
D. perfect

6. Evidence suggests that there may be _______ momentum and ________ reversal patterns in
stock price behavior.
A. short-run, short-run
B. long-run, long-run
C. long-run, short-run
D. short-run, long run.

7. __________ is the return on a stock beyond what would be predicted from market
movements alone.
A. A normal return
B. A subliminal return
C. An abnormal return.
D. An excess return

8. You believe that stock prices reflect all information that can be derived by examining market
trading data such as the history of past stock prices, trading volume or short interest but you do not
believe stock prices reflect all publicly available or inside information. You are a proponent of
____________.
A. semi-strong
B. strong
C. weak.
D. perfect

9. Choosing stocks by searching for predictable patterns in stock prices is called ________.
A. fundamental analysis
B. technical analysis.
C. index management
D. random walk investing