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Article 2 The theory of stock market efficiency Dr. Yang April 15, 2015 Group 2 Greg Werthman Kapil Jain Aaron Cyr Richard Oluoha Jen-Chiang La
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What is market efficiency? Whether the stock prices can always incorporate and reflect all relevant information. Market Efficiency is the degree to which stock prices reflect all available, relevant information. Market efficiency was developed in 1970 by Economist Eugene Fama who's theory efficient market hypothesis (EMH), stated that it is not possible for an investor to outperform the market because all available information is already built into all stock prices.
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Efficient Market Hypothesis (EMH) Assumptions: ●All investors are rational and strictly supervise the market. ●Investors also react to information at the same way ●Stock price = Fair price ●The stock prices have fully and instantaneously reflected all relevant information. (Information Efficiency) ●Information is costless
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In reality Not all investors are rational Investors react to the same information differently Information is not always efficient Information is not costless Therefore………
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Three forms of Market Efficiency Weak Form Efficiency: Stock prices fully and instantaneously reflect all historical price and return information (but not publicly available info) Semi Strong Form Efficiency: Stock prices fully and instantaneously reflect all publicly available information Strong Form Efficiency: Stock prices fully and instantaneously reflect all relevant information ( even hidden or "insider" information )
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How to determine which form our market is? For weak form: Past prices of a stock are reflected in today’s stock price The tests of the weak form of the EMH can be categorized as: Statistical Tests for Independence - Examples of these tests are the autocorrelation tests (returns are not significantly correlated over time) and runs tests (stock price changes are independent over time). Trading Tests - Past returns are not indicative of future results, therefore, the rules that traders follow are invalid. An example of a trading test would be the filter rule, which shows that after transaction costs, an investor cannot earn an abnormal return.
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How to determine which form our market is? For semi strong form: market is reflective of all publicly available information Semi-strong Form Tests Event Tests - The semi-strong form assumes that the market is reflective of all publicly available information. An event test analyzes the security both before and after an event, such as earnings. The idea behind the event test is that an investor will not be able to reap an above average return by trading on an event. Regression/Time Series Tests - Time series forecasts returns are based on historical data. As a result, an investor should not be able to achieve an abnormal return using this method.
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How to determine which form our market is? For strong form: The market is reflective of all information, both public and private Strong-Form Tests The tests for the strong-form center around groups of investors with excess information. These investors are as follows: Insiders - Insiders to a company, such as senior managers, have access to inside information. SEC regulations forbid insiders for using this information to achieve abnormal returns. Exchange Specialists - An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that exchange specialists can achieve above average returns with this specific order Institutional money managers - Institutional money managers, working for mutual funds, pensions and other types of institutional accounts, have been found to have typically not perform above the overall market benchmark on a consistent basis
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Limitation ●Defects in efficiency as a model of market o The theory’s failure to incorporate information acquisition and processing costs ●Empirical Anomalies o The theory’s failure to explain certain aspects of share price behavior ●Problem in testing the efficiency model o Problem in testing the on the returns earned when trading on public information against the returns otherwise expected from passive investing
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Anomalies Price overreactions Excess volatility Price underreactions to earnings The failure of CAPM The explanatory power of Non-CAPM factors Seasonal patterns
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Defects in efficiency as a model of market Failure to incorporate information acquisition and processing costs Heterogeneous information and believes A brief digression on the role of security analyst Failure to consider transaction costs Market microstructure effects
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Problem in testing the efficiency model Change in riskless rates and risk premiums Trends in real rates and market risk premiums Change in betas Seasonal patterns in betas
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Behavioral Finance ● Behavioralists suggest that investors place too much weight on current information, focusing myopically on short term earnings, while ignoring a company’s long term prospects
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Concluding Observations ●Are stock market efficient? Yes & No o Yes - Research has provided insight into stock behavior that may suggest that the efficient market theory is correct o No - Like all theories, the market efficient theory is imperfect and is a limited way of of viewing stock markets
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Thank You!
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