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RSM332 week11 - market efficiency

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Rotman Commerce
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Otto Yung

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RSM332 - Week #11 Operational efficiency An efficient market condition in which transaction costs are low. Allocational efficiency An efficient market condition in which there are enough securities to efficiency allocate risk. Informational efficiency An efficient market condition in which important information is reflected in share prices. That is, material facts are publicly disclosed and investors use all publicly available information in their investment decisions. Efficient market A market that reacts quickly and relatively accurately to new public information, which results in prices that are correct (fairly valued) on average. True market efficiency is not practical in real life because it requires instantaneous and perfect price adjustments. Assumptions of an efficient market 1. There are a large number of rational, profit-maximizing investors who actively analyze, value, and trade securities. The markets are perfectly competitive (price takers). 2. Information is costless and widely available at the same time. 3. Information arrives randomly (announcements are not expected or related to one another). 4. Investors react quickly and fully to new information (reflected in stock prices). Sell-side analysis Securities analysts whose job it is to monitor companies and regularly report on their value through earnings forecasts and buy/sell/hold recommendations; they work for investment banks that underwrite and sell securities to the public. Buy-side analysis Securities analysts whose job it is to evaluate the research and recommendations produced by the sell-side analysts; they work for institutions in the capital market that invest in securities. Implications of market efficiency 1. Technical analysis is not likely to be rewarded by consistent abnormal returns. This is because markets appear to be, at minimum, weak form efficient. 2. Fundamental analysis is not likely to be rewarded by consistent abnormal returns, although some opportunities are available. This is because one’s analysis would have to be consistently superior to earn higher returns. In reality, average, or below-average, analysis consistently results in subpar performance. 3. Active trading strategies are not likely to outperform passive strategies on a consistent basis. Efficient market hypothesis (EMH) The theory that markets are efficient and, therefore, that prices accurately reflect all available information at any given time. Weak form EMH Security prices full reflect all market data, which refers to all past price and volume trading information. All past data is already reflected in current prices and is of no value in predicting future price changes. Weak form evidence Tested by finding empirical evidence for the independence of price changes. Evidence for:  serial correlation tests: correlation between price changes for various lags (a day, a month, etc.)  runs (signs) tests: classify each price change by +/0/- and examine if they are any patterns  these tests do tend to suggest that price changes are independent of one another If any trading rule that attempts to exploit historical trading data is able to consistently generate abnormal risk-adjusted returns after trading costs, then weak form efficiency would be contradicted:  technical analysts (chartists) believe this is possible  evidence suggests that technical trading rules do not consistently produce abnormal returns Evidence against:  evidence of long-term “reversal” patterns in stock returns  people tend to overreact to new information allowing contrarian strategies to work  recent three- to five-year “losers” tend to outperform in the future  recent three- to five-year “winners” tend to underperform in the future  evidence of short-term momentum patterns in stock returns  stocks with high 3- to 12-month returns tend to outperform in the following months  this is the opposite of the long-term reversal pattern  evidence of seasonal patterns in stock returns  stock returns are statically higher
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