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Chapter 8 Stock Price Behaviour and Market Efficiency.docx

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Ryerson University
FIN 501
Edward Blinder

FIN501 investment analysis I CHAPTER 8 STOCK PRICE BEHAVIOUR AND MARKET EFFICIENCY INTRODUCTION TO MARKET EFFICIENCY  Efficient market hypothesis (EMH): the hypothesis stating that, as a practical matter, investors cannot consistently “beat the market” o In a practical matter, organized financial markets are efficient WHAT DOES “BEAT THE MARKET” MEAN?  Excess return: a return in excess of that earned by other investments having the same risk o The difference between what that investment earned and what other investments with same risk earned o Positive excess return means that an investment has outperformed other investments of the same risk FOUNDATIONS OF MARKET EFFICIENCY  Three economic forces can lead to market efficiency: 1. Investor rationality 2. Independent deviations from rationality 3. Arbitrage  “Rational” means that only investors do not systematically overvalue or undervalue financial assets in light of the information they possess  Market efficiency does not require everybody be rational, just that somebody is FORMS OF MARKET EFFICIENCY  A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return  The particular sets of information used in the three forms of market efficiency are nested: i. Weak-form efficient market – information reflected in past prices and volume figures is of no value in beating the market ii. Semistrong-form efficient market – publicly available information of any and all kinds of no use in beating the market iii. Strong-form efficient market – no information of any kind, public or private is useful in beating the market SOME IMPLICATIONS OF MARKET EFFICIENCY  Random walk: no discernible pattern to the path that a stock price follows through time o Related to weak-form version of efficient market hypothesis because past knowledge of the stock price is not useful in predicting future stock prices  In a semistrong-form, the efficient market hypothesis is the simple statement that stock prices fully reflect publicly available information and their view of the future prospects for the stock  Prices could adjust to a positive news announcement in three basic ways: i. Efficient market reaction – price instantaneously adjusts to, and fully reflects, new information  There is no tendency for subsequent increases or decreases to occur ii. Delayed reaction – price partially adjusts to the new information, but days elapse before the price completely reflects new information iii. Overreaction and correction – price overadjusts to the new information; it overshoots and the appropriate new price but eventually falls to the new price  Event study: a research method designed to help study the effects of news on stock prices  Abnormal returns: the remaining return on a stock after overall market returns have been removed ABNORMAL RETURN = OBSERVED RETURN – EXPECTED RETURN INFORMED TRADERS AND INSIDER TRADING  Informed trader: an investor who makes a buy or sell decision based on public information and analysis  Insider trading: someone how has access to access to information not available to the public o Material non-public information: private knowledge that can substantially influence the share price of a stock o When an illegal insider trade occurs, there is a tipper and a tippee, and uses the information in an attempt to make a profit FIN501 investment analysis I HOW EFFICIENT ARE MARKETS?  Market efficiency is difficult to test for four basic reasons: i. The risk-adjustment problem  We do not know what we mean by risk, much less how to measure it precisely and then adjust for it, thus what appears to be a positive excess return may just be the result of a faulty risk-adjustment procedure ii. The relevant information problem  We have to recognize that we cannot possibly know all the information that may have been underlying that market behaviour  Without all relevant information, we cannot tell if some observed price behaviour is inefficient iii. The dumb luck problem  One type of evidence frequently cited to prove that markets can be beaten is the enviable track record for certain legendary investors iv. The data snooping problem  Researchers have discovered extremely simple patterns that, at least historically, have b
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