· Cost and time are involved in processing new information
· Gains from information trading are less than transaction costs
· Arbitrage is not riskless
Showing posts with label Efficient Capital Markets. Show all posts
Showing posts with label Efficient Capital Markets. Show all posts
Wednesday, November 26
Reasons for the persistence of mispricing
· Lack of theoretical explanation
· Transaction cost
· Small profit opportunities
· Trading restriction
· Irrational behavior
· Transaction cost
· Small profit opportunities
· Trading restriction
· Irrational behavior
Common bias for distorting the tests of mispricing
Measurement of abnormal return – not risk-adjusted
Strategy risk
Data mining – related to Type I error that the statistically significant relationships occur by chance in fact
Survivorship bias –some funds and companies that are ceased and dropped out of the performance histories lead to upward bias on returns
Sample selection bias – sample do not has the same characteristics as the population
Small sample bias – Inferences drawn from a small sample or short time period may be incorrect
Nonsynchronous trading – price date for stocks that trade infrequently can distort the tests
Bias
Overconfidence bias
Analyst overconfidence in their earning forecasts which lead to overemphasize the impact of good news and to underestimate the impact of bad news.
Confirmation bias
People tend to seek out supporting information after making a decision and avoid new information that is against their decision
Escalation bias
Investors tend to throw good money after bad – the practice of averaging
down as the price of a stock falls.
Analyst overconfidence in their earning forecasts which lead to overemphasize the impact of good news and to underestimate the impact of bad news.
Confirmation bias
People tend to seek out supporting information after making a decision and avoid new information that is against their decision
Escalation bias
Investors tend to throw good money after bad – the practice of averaging
down as the price of a stock falls.
Behavioral finance
Consider psychological characteristics of investor behavior that explain some anomalies negating EMH.
Portfolio management add value in efficient markets
Portfolio managers can still add value by implementing the portfolio management process.
1. Determine investor’s risk and return objectives.
2. Specify policies and strategies required to meet objectives.
3. Allocate funds according to investment policy.
4. Diversify investments to eliminate unsystematic risk.
5. Monitor capital markets and client’s needs to rebalance if necessary.
6. Minimize taxes, turnover of assets and liquidity costs.
1. Determine investor’s risk and return objectives.
2. Specify policies and strategies required to meet objectives.
3. Allocate funds according to investment policy.
4. Diversify investments to eliminate unsystematic risk.
5. Monitor capital markets and client’s needs to rebalance if necessary.
6. Minimize taxes, turnover of assets and liquidity costs.
Investment in index fund
Given the assumptions on the EMH, no investor is able to generate an abnormal return in the market. An investor should thus focus on the minimizing his costs to invest.
To achieve a market rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the investor to achieve the market rate of return in a cost effective manner.
To achieve a market rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the investor to achieve the market rate of return in a cost effective manner.
Implications of stock market efficient
Implications for technical analysis: dire
Technical analysis is based on past results.
Implications for fundamental analysis: dire,
All publicly information is reflected
Implications for portfolio manager:
Active managers will under perform the market especially after management fees are taken into account.
Technical analysis is based on past results.
Implications for fundamental analysis: dire,
All publicly information is reflected
Implications for portfolio manager:
Active managers will under perform the market especially after management fees are taken into account.
Market Anomalies
Earnings Reports (against EMH)
Investor can profit from investing immediately when a company reports because it takes time for the market to absorb the new information.
January Anomaly (against EMH)
January effect indicates that as a result of tax-related moves, investors have been shown to profit by buying stocks in December as they are being sold for losses and then selling them again in January.
Price-Earnings Ratio (against EMH)
Investors can profit by investing in companies with a low P/E ratio.
Price-Earnings/Growth (PEG) Ratio (against EMH)
Investors profit by investing in companies with low PEG ratios.
Size Effect (against EMH)
Smaller companies, on a risk-adjusted basis, have greater returns their larger peers.
Neglected Firms (against EMH)
Neglected firms are firms that Wall Street analysts deem too small to cover. As a result, these firms tend to generate larger levels of return.
Investor can profit from investing immediately when a company reports because it takes time for the market to absorb the new information.
January Anomaly (against EMH)
January effect indicates that as a result of tax-related moves, investors have been shown to profit by buying stocks in December as they are being sold for losses and then selling them again in January.
Price-Earnings Ratio (against EMH)
Investors can profit by investing in companies with a low P/E ratio.
Price-Earnings/Growth (PEG) Ratio (against EMH)
Investors profit by investing in companies with low PEG ratios.
Size Effect (against EMH)
Smaller companies, on a risk-adjusted basis, have greater returns their larger peers.
Neglected Firms (against EMH)
Neglected firms are firms that Wall Street analysts deem too small to cover. As a result, these firms tend to generate larger levels of return.
Strong-Form EMH
· Security prices reflect all information both public and private
· No investor would be able to profit above the average investor even if he was given new information.
Test results:
Supported by evidence that after accounting for transaction costs security analysts and portfolio managers cannot generate excess returns. Corporate insiders and stock market specialists are exceptions who can generate excess returns. But Securities analysts are not able to outperform buy and hold strategy
· No investor would be able to profit above the average investor even if he was given new information.
Test results:
Supported by evidence that after accounting for transaction costs security analysts and portfolio managers cannot generate excess returns. Corporate insiders and stock market specialists are exceptions who can generate excess returns. But Securities analysts are not able to outperform buy and hold strategy
Semi-strong form EMH:
Semi-strong form EMH:
· Security prices reflect all publicly-available information.
· stocks adjust quickly to absorb new information.
· Fundamental analysis cannot generate excess returns either
Tests:
Event test
Given the assumption that the market is reflective of all publicly available information, an event test analyzes the security both before and after an event. 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
Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.
Abnormal return = Actual Returnl - Market Return;
Risk adjusted abnormal return = Actual Returnl -Market Return x beta
Test Result: mixed.
The semi-strong form EMH, at times, is both supported and not supported by the tests and analysis done. There has been some evidence that securities are not reflective of the semi-strong form EMH.
Supported by event studies: abnormal returns around stock splits (no LT or ST impact), IPOs (price adjustment occurs within 1 day of offering , exchange listing do not cause permanent change in LR value. and accounting changes).
Rejected by time series tests: term structure of interest rates and dividend yield can be used predict LR prices, earning surprise not be reflected as fast as semistrong EMH expected. Thus one can predict for individual price:
Calendar studies - January anomaly & weekend effect does work
Cross sectional tests -neglected, low PE, and high P/B firms (regardless of the size) have higher returns; small size firms have higher return
· Security prices reflect all publicly-available information.
· stocks adjust quickly to absorb new information.
· Fundamental analysis cannot generate excess returns either
Tests:
Event test
Given the assumption that the market is reflective of all publicly available information, an event test analyzes the security both before and after an event. 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
Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.
Abnormal return = Actual Returnl - Market Return;
Risk adjusted abnormal return = Actual Returnl -Market Return x beta
Test Result: mixed.
The semi-strong form EMH, at times, is both supported and not supported by the tests and analysis done. There has been some evidence that securities are not reflective of the semi-strong form EMH.
Supported by event studies: abnormal returns around stock splits (no LT or ST impact), IPOs (price adjustment occurs within 1 day of offering , exchange listing do not cause permanent change in LR value. and accounting changes).
Rejected by time series tests: term structure of interest rates and dividend yield can be used predict LR prices, earning surprise not be reflected as fast as semistrong EMH expected. Thus one can predict for individual price:
Calendar studies - January anomaly & weekend effect does work
Cross sectional tests -neglected, low PE, and high P/B firms (regardless of the size) have higher returns; small size firms have higher return
Weak form EMH:
· Security prices reflect all historical information.
· The rates of return on the market should be independent; past rates of return have no effect on future rates.
· technical analysis cannot generate excess returns
Tests:
· Statistical Tests for Independence
· To examine the weak form of the EMH test for the independence assumption that the rate of return on the market are independent.
Example:
Autocorrelation test - security returns are not significantly correlated over times
Runs test- stock price changes are independent over time
Test result: support
The weak-form EMH is supported by the tests and analysis done. Essentially, the weak-form holds that abnormal returns are not achievable with the use of past-historical data as a means to generate returns.
Supported by statistical tests {autocorrelation – security returns are not significantly correlated over times and runs- stock price changes are independent over time}
Trading rule tests that show no excess return can be generated after accounting for transaction costs.(filter rules entail trading stocks when rices move up or down certain amounts).
Other trading rules- show that it does not outperform a buy-&-hold strategy after taking account of commission.
· The rates of return on the market should be independent; past rates of return have no effect on future rates.
· technical analysis cannot generate excess returns
Tests:
· Statistical Tests for Independence
· To examine the weak form of the EMH test for the independence assumption that the rate of return on the market are independent.
Example:
Autocorrelation test - security returns are not significantly correlated over times
Runs test- stock price changes are independent over time
Test result: support
The weak-form EMH is supported by the tests and analysis done. Essentially, the weak-form holds that abnormal returns are not achievable with the use of past-historical data as a means to generate returns.
Supported by statistical tests {autocorrelation – security returns are not significantly correlated over times and runs- stock price changes are independent over time}
Trading rule tests that show no excess return can be generated after accounting for transaction costs.(filter rules entail trading stocks when rices move up or down certain amounts).
Other trading rules- show that it does not outperform a buy-&-hold strategy after taking account of commission.
Tuesday, November 25
Efficient Markets and its Requirements
Efficient market:
Market that prices of securities reflect all available information.
Requirements for market efficiency:
· large number of profit maximizing, independent buyers and sellers
· random order of new information
· rapid adjustment of price expectations in response to news, not assume correctly adjust but are unbiased
· risk reflected in security prices and returns. If assumptions not holdm, excess returns are possible.
Market that prices of securities reflect all available information.
Requirements for market efficiency:
· large number of profit maximizing, independent buyers and sellers
· random order of new information
· rapid adjustment of price expectations in response to news, not assume correctly adjust but are unbiased
· risk reflected in security prices and returns. If assumptions not holdm, excess returns are possible.
Subscribe to:
Posts (Atom)
