Week 7

MONASH
BUSINESS
SCHOOL
Week 07
BFF5220 Applied Investments
Market Efficiency
Dr. Viet N. Cao

How Weekly Topics Are Related
W1 - Trading Techniques,
Return and Risk Measures
W2 - Portfolio tools W3&4 – Asset ke Relevant to
W4, 5 & 6 - Valuation Fundamental
Theory Pricing Models
Analysts
Individual MST
What if asset pricing
models fail to explain Relevant to
stock returns? Group
Assignment Quant Analysts
W7&8 - Market (incl. trading
Should we bother Efficiency and simulation)
with equity valuation? Behavioural Finance
W9&10 – Options Trading Weekly tutorial submission

Strategies and Valuation
W11 – Futures, Forwards, and Swap W12 – Fixed Income Market
MONASH
BUSINESS 2
SCHOOL
MONASH
BUSINESS
SCHOOL
Week 07: Market Efficiency
Concept of Market Efficiency

Value of Information and Market Efficiency
Testing of Market Efficiency – Weak Form
Testing of Market Efficiency – Semi Strong Form
Testing of Market Efficiency – Strong Form
(BKM Ch. 11,
McLean and Pontiff, Journal of Finance, 2016 – Introduction Only – available on Moodle,
Shleifer and Vishny, Journal of Finance, 2007 – Introduction Only – available on Moodle.)
3
• Perfect Capital Market
• Markets are frictionless (no trans cost, taxes, perfectly
divisible and marketable assets)
• Perfect competition in securities market
• All investors are rational expected utility maximisers
• Markets are informationally efficient
• Informational Efficiency
• Information is costless
• All investors receive information simultaneously
 Implies Allocational and Operational Efficiency
MONASH
BUSINESS
4 SCHOOL
• Allocational Efficiency
• Scarce savings are optimally allocated to productive
investments
• This happens when:
Cost of capital = Marginal rate of risk adjusted return
• Operational Efficiency
• No cost of transferring funds
• E.g. no transaction cost, markets are perfectly liquid
MONASH
BUSINESS
5 SCHOOL
• Capital Market Efficiency (Much less restrictive than “Perfect Capital Market”)
• Prices fully and instantaneously reflect all available
information
Asset prices accurately signal for capital allocation
(i.e. Allocational Efficiency)
• Fama (1970, 1976) operationalized ME depending on

the information set available to investors:
• Weak Form
• Semi-strong Form
• Strong Form
MONASH
BUSINESS
6 SCHOOL
• Fama’s (1970) Three Forms of Market Efficiency
• Strong form: Investors get access to all information,
including past stock market infor, public infor (e.g. earnings
announcements) and private (insider) infor
• Semi-strong form: past stock market infor + public infor
• Weak form: past stock market infor
MONASH
BUSINESS
7 SCHOOL
• Fama’s (1970) Three Forms of Market Efficiency
Can anyone consistently earn abnormal returns?
Do investors systematically misinterpret information?
MONASH
BUSINESS
8 SCHOOL
• Fama’s (1970) Market Efficiency - Misconceptions
• Efficiency implies predictability
• It is the predictability of Abnormal Returns that implies
inefficiency
• Efficiency is not against the predictability of Expected Returns
• Prices are randomly set
• vs. random information arrival
• Large movements in prices are inconsistent with Market
Efficiency
• Expected return = Observed return
• Investors will all perform equally
• Market corrections have to occur
MONASH
BUSINESS
9 SCHOOL
• Shiller (1981) on irrational exuberance:
Source: Shiller (2013),

Nobel Prize Speech.
MONASH
BUSINESS
10 SCHOOL
MONASH
BUSINESS
SCHOOL

(BKM Ch. 11)
11
• Grossman – Stiglitz Paradox:
• If capital markets are efficient  No one could earn
abnormal returns
• Without abnormal returns  No strong incentive
to acquire information
How can prices reflect information then?
And how can a securities analysis industry exist?
Only when infor is costless and all investors have zero

abnormal returns
MONASH
BUSINESS
12 SCHOOL
Cornell and Roll’s (1981) model of Market Efficiency with
costly information acquisition
An illustration:
• Investors choose between 2 strategies:
• Analyst strategy: pay c2 = 8% for acquiring valuable infor
• Random selector’s strategy: pay c1 = 4% for the right to
trade
• Costly information doubles the competitive advantage d
whenever investors choose to acquire valuable infor
• The normal rate of return r = 6%
MONASH
BUSINESS
13 SCHOOL
The Opponent Analyses Information
Yes No
The Investor Yes r – c2 = 6% - 8% = -2% dr – c2= 2x6% - 8% = 4%
Analyses
Information No r/d – c1 = 6%/2 – 4% = -1% r – c1 = 6% - 4% = 2%
In equilibrium, a mixed strategy with p probability of using

analysts and (1-p) probability of resigning to random selection
satisfies: Payoff to analysis strategy = Payoff to random selection
− + 1− − = ⁄ − + (1 − )( − )
1− + − 2
= =
2 − − ⁄ 3 MONASH
BUSINESS
14 SCHOOL
Key take-aways:
• There exists value 0<p<1 so that investors may use
analysts with p probability and choose randomly
with (1-p) probability
• Gross return for using analysts is higher than gross
returns for random selection
• Once accounting for infor cost, both strategies have
the same net return
 The security analysis industry can exist!
MONASH
BUSINESS
15 SCHOOL
Who should collect information?
• Economies of scales:
• Investors with a lot of money
• Agents who manage a lot of money
• Do fund managers outperform the market
consistently after adjusting for risks and accounting
for expenses?
Evidence suggests that no one could beat the
market consistently!
Beware of survivorship bias in evaluating fund
performance!
MONASH
BUSINESS
16 SCHOOL
MONASH
BUSINESS
SCHOOL

(BKM Ch. 11)
17
Momentum Trading Strategies
• Positive serial correlation at stock level over medium term
• Jegadeesh and Titman (1993, 2001): Return over the previous 3
to 12 months is positively related to the future 3 to 12 months’
return  J x 1 x K strategies
• J = formation period (3, 6, 9 or 12 months)
• 1: skipping one month between J and K
• K = holding period (3, 6, 9 or 12 months)
• Trading strategy: Long Winners, Short Losers, hold medium
term
• Does not appear to be a risky strategy!  EMH violation
• Cannot be reconciled with long run return reversal
MONASH
BUSINESS
18 SCHOOL
US Market - Monthly return to the 6x1x6 momentum strategy using equally
weighted portfolios
1.20 1.10
1.09
1.04
1.00 0.95
0.80
0.60
0.40
0.20
0.00
1965 - 1989 1965 - 1998 1965 - 1989 1990 - 1998
Jegadeesh & Titman (1993) Jegadeesh & Titman (2001)
MONASH
BUSINESS
19 SCHOOL
1.4 1.32
1.26
1.2 1.1 1.09
0.97 0.99
1 0.93 0.89
0.8
0.8 0.72
0.64
0.6
0.4
0.16
0.2
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1.37 1.43
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MONASH
BUSINESS
20 SCHOOL
Short-run Short-term reversal (1934-1987)
Return Reversal 0.025
• Jegadeesh (1990): 0.02

the stock return in 0.015
the past month is
0.01
negatively related
to the stock return 0.005
in the following
0
month
-0.005
 Long Losers, Short
Winners, hold 1 -0.01
month (nearly 2% -0.015

per month!)
MONASH
BUSINESS
21 SCHOOL
Long-run
Return Reversal
• De Bond and
Thaler (1985): the
stock return in the
past 3 to 5 years is
negatively related
to the stock return
in the following 3
to 5 years
 Long Losers, Short
Winners, hold long
run
MONASH
BUSINESS
22 SCHOOL
The Size Effect
• The Size effect: Banz (1981)
 Investment strategy:
Long Small, Short Big stocks
 Keim (1983): The small

firms in January effect
(i.e. this effect is the
strongest in January)
US market: The size effect 1926 – 2007 (Kenneth French’s website)

MONASH
BUSINESS
23 SCHOOL
MONASH
BUSINESS
SCHOOL

Testing of Market Efficiency – Semi-Strong Form
(BKM Ch. 11)
24
Testing of Market Efficiency – Semi-strong Form
Return Predictability at Stock Level
• The value effect:
Value stocks
 Low growth
 High book value of equity
 High B/M ratio
 Generally high ratios of
Fundamentals to Price
(E/P, D/P, CF/P, Sales / P…)
outperform growth stocks.

Trading strategy: Long Value, short Growth
MONASH
BUSINESS
25 SCHOOL
• The value effect in the times of Graham and Dodd:
Value investing in Benjamin Graham’s own words…
(http://www.forbes.com/2009/02/23/graham-buffett-value-personal-finance_benjamin_graham.html)
Invest with a margin of safety

“Margin of safety is the principle of buying a security at a significant discount to its intrinsic
value, which is thought to not only provide high-return opportunities but also to minimize the
downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1
for 50 cents. He did this very, very well.
To Graham, these business assets may have been valuable because of their stable earning
power or simply because of their liquid cash value. It wasn't uncommon, for example, for
Graham to invest in stocks in which the liquid assets on the balance sheet (net of all debt)
were worth more than the total market cap of the company (also known as "net nets" to
Graham followers). This means that Graham was effectively buying businesses for nothing.
While he had a number of other strategies, this was the typical investment strategy for
Graham.”
MONASH
BUSINESS
26 SCHOOL
• The value effect - The Old vs New economy:
Source: Falato et al. (Journal of Finance, 2022)
MONASH
BUSINESS
27 SCHOOL
• The value effect in the new economy:
Source: The Economist, Nov 12, 2020 Source: Financial Times, Nov 18, 2020
MONASH
BUSINESS
28 SCHOOL
• Neglected vs. Glamour effect:
Glamour stocks:
 Large trading volume
 Extensive media coverage
 Are widely believed to be undervalued
underperform neglected stocks
Trading strategy: Long Neglected, Short Glamour

Question: Do the best companies make the best stocks?
MONASH
BUSINESS
29 SCHOOL
Testing of Market Efficiency
using Long-Short trading strategies
Asking whether the return to the Long-Short strategy is

(a) driven completely by exposures to priced risk factors  M. Efficiency, or
(b) from some temporary mispricing (i.e., non-risk sources) M. Inefficiency
Alpha from the return regressions using Asset Pricing Models!
Note: The Long-Short portfolios (e.g., SMB, HML, UMD, etc…) are already zero
net-investment.
(S – rF) – (B – rF) = S-B = SMB
(H-rF) – (L-rF) = H-L = HML
(U-rF) – (D-rF) = U-D = UMD
 No deduction of rF from the return to the Long-Short portfolio!
MONASH
BUSINESS
30 SCHOOL
using Event Studies
• Empirical financial research tool that enables us to assess the

impact of a particular event on a firm’s stock price.
• The abnormal return due to the event is the difference

between the stock’s actual return and a proxy for the stock’s
expected return in the absence of the event.
• Returns are adjusted for risks to see if they are truly ‘abnormal’
MONASH
BUSINESS
31 SCHOOL
using Event Studies
• Returns are adjusted for risks to see if they are truly ‘abnormal’
Market Model approach:
a. rt = a + brmt + et
(Expected Return) For a short window around an
b. Abnormal Return = event, we can reasonably expect
the intercept a to stay unchanged.
(Actual - Expected)
et = rt - (a + brMt)
• Other models may also be used to adjust returns for risks,
• Or simply, et = rt - rMt
• Alternatively, Expected Return = Return to other comparable stocks
matched on key characteristics.
MONASH
BUSINESS
32 SCHOOL
Event Studies
Reality 1 - Reality 2 -
Market Efficiency Underreaction Overreaction
Any other possibility?
MONASH
BUSINESS
33 SCHOOL
Event Studies
Takeover announcement (Keown and Pinkerton, 1981)
MONASH
BUSINESS
34 SCHOOL
Event Studies
Earnings Announcement (Rendleman et al., 1982)
MONASH
BUSINESS
35 SCHOOL
Event Studies
CEO’s sudden death (Johnson and Magee 1985):
MONASH
BUSINESS
36 SCHOOL
Event Studies
CEOs’ sudden death (Quigley et al., 2017)
MONASH
BUSINESS
37 SCHOOL
Event Studies
How quickly did the market react to news about COVID vaccine success?
Travel-Exposed Stocks vs. Food Delivery Stocks
Source: Financial
Times, Nov 10,
2020
MONASH
BUSINESS
38 SCHOOL
Event Studies
How did the market react to the USPTO’s decision on CRISPR patent dispute?
MONASH
BUSINESS
39 SCHOOL
Event Studies
How did the market react to the USPTO’s decision on CRISPR patent dispute?
Source: https://www.bloomberg.com/news/articles/2022-03-01/intellia-sinks-after-patent-ruling-overshadows-crispr-promise
MONASH
BUSINESS
40 SCHOOL
Event Studies
How does the financial market react to central banks’ rate hikes?
Source: https://www.cnbc.com/2022/09/21/fed-rate-hike-september-2022-.html
MONASH
BUSINESS
41 SCHOOL
MONASH
BUSINESS
SCHOOL

Testing of Market Efficiency – Semi-Strong Form
(BKM Ch. 11)
42
Insider Trading
• Plenty of evidence that insiders make abnormal profit
• Jaffe (1974): stock price rises (falls) after intensive insider
buy (sell)
• Can investors benefit from following insider trades?

• Insider trades are registered in SEC’s Official Summary and
become public information
• It might be too late then!
• Who could possibly be “insiders”?
MONASH
BUSINESS
43 SCHOOL
Who are Insiders?– Hacking of earnings news (Akey et al., Journal of
Financial Economics, 2022)
MONASH
BUSINESS
44 SCHOOL
Who are Insiders?– Hacking of earnings news (Akey et al., Journal of
MONASH
BUSINESS
45 SCHOOL
Who are Insiders?– Hacking of soft information (Akey et al., Journal of
MONASH
BUSINESS
46 SCHOOL
Positive vs Negative soft information (Akey et al., Journal of Financial Economics,
2022)
MONASH
BUSINESS
47 SCHOOL
Testing of Market Efficiency in reflection
Interpretation of Evidence
• Risk premium or market inefficiency?
Behavioural Finance
• Data mining / statistical bias / investor awareness

• If analysing past data over and over along enough
dimensions, some criteria may appear to predict returns
• Are the effects robust over time and across markets?
• Does academic research destroy stock return predictability?
(McLean and Pontiff, 2016)
MONASH
BUSINESS
48 SCHOOL
Testing of Market Efficiency – Interpretation
Interpretation of Evidence
• Limits-to-Arbitrage
The persistence of a return pattern may be due to limits-to-
arbitrage
Some examples:
• Model risk: How do you know when a security is truly mispriced?
• Fundamental risk: Changes in fundamentals can wipe out arbitrage
profit, making the strategy risky.
• Excess volatility and idiosyncratic risk: can deter arbitrageurs’
participation to eliminate mispricing.
• Transaction costs: Difficult to arbitrage mispriced stocks, especially the
short leg, which involves selling overpriced ones.
• Agency conflict between investors and investment professionals who
manage these investors’ money (Shleifer and Vishny, 1997).
MONASH
BUSINESS
49 SCHOOL
MONASH
BUSINESS
SCHOOL
Thank you!

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MONASH

Dr. Viet N. Cao

W9&10 – Options Trading Weekly tutorial submission

W11 – Futures, Forwards, and Swap W12 – Fixed Income Market

Week 07: Market Efficiency

Concept of Market Efficiency

Cost of capital = Marginal rate of risk adjusted return

• Fama (1970, 1976) operationalized ME depending on

• Semi-strong form: past stock market infor + public infor

• Weak form: past stock market infor

Can anyone consistently earn abnormal returns?

Do investors systematically misinterpret information?

Source: Shiller (2013),

Week 06: Market Efficiency

Concept of Market Efficiency

Only when infor is costless and all investors have zero

In equilibrium, a mixed strategy with p probability of using

Week 06: Market Efficiency

Concept of Market Efficiency

Jegadeesh & Titman (1993) Jegadeesh & Titman (2001)

• Jegadeesh (1990): 0.02

month (nearly 2% -0.015

 Keim (1983): The small

US market: The size effect 1926 – 2007 (Kenneth French’s website)

Week 06: Market Efficiency

Concept of Market Efficiency

outperform growth stocks.

Invest with a margin of safety

Source: Falato et al. (Journal of Finance, 2022)

Trading strategy: Long Neglected, Short Glamour

Asking whether the return to the Long-Short strategy is

Alpha from the return regressions using Asset Pricing Models!

• Empirical financial research tool that enables us to assess the

• The abnormal return due to the event is the difference

Any other possibility?

Week 06: Market Efficiency

Concept of Market Efficiency

• Can investors benefit from following insider trades?

• Who could possibly be “insiders”?

• Data mining / statistical bias / investor awareness

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