2015, Study Session # 13, Reading # 47

MARKET EFFICIENCY
E(R)
TA
EM
ME

= Expected Return
= Technical Analysis
= Emerging Markets
= Market Efficiency

47.a

Informationally efficient CM current security price reflect fully, quickly &

rationally all available information (you cant beat the market).

Perfectly efficient market passive investment strategy (indexing), because
active investment will underperform (transaction cost & management fees).

If time lag b/w information dissemination & information reflection in securities
prices positive risk adjusted return is possible.

Only unexpected new information should move prices.

CM
TC
MV
IV

= Capital Market
= Transaction Cost
= Market Value
= Intrinsic Value

47.b

MV current price.

IV = value placed on an asset based on rational investors understanding of its
characteristics.

If MV < IV buy the asset & vice versa (inefficient markets).

More complex an assets future cash flows more difficult is to determine its
IV.

47.c
Markets are generally in b/w perfectly efficient & completely inefficient.

Factors Affecting Degree of ME

No. of Market Participants

Availability of Information

No. of asset market followers (e.g. investors, analyst etc),

the market efficiency

More information is available to investors higher the

market efficiency.

Emerging markets
information availability
efficient
markets.

Access to information should not favor one party over another
(insider trading should be prohibited).

Transaction & Information Acquisition Cost

Impediments to Trading

Arbitrage buying an asset in one market & simultaneously

selling it at a higher price in another market.

Impediments to arbitrage (e.g.
TC), allow some price
inefficiencies.

Short selling improves ME.

If investors can earn superior returns, after deducting

information acquisition costs, the market is viewed as inefficient.

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2015, Study Session # 13, Reading # 47

47.d

Forms of ME

Weak-Form ME

Current security prices fully reflect all
past security market data.

Price changes will be independent from
one period to the next (past price &
volume has no predictive power).

Positive risk adjusted returns are not
possible by using technical analysis.

Semi-Strong Form ME

Security prices reflect publicly known and
available information.

Fundamental analysis will not work for
positive risk adjusted return.

Strong-Form ME

Security prices fully reflect all public &
private information.

No group of investor has monopolistic
access to information (no one can
achieve positive abnormal return).

Evidence support that markets are not
strong-form efficient.

47.e

Abnormal Profit
>
equilibrium E(R) reject the
<
hypothesis of efficient prices.
If returns

Technical Analysis

Seeks to earn positive risk-adjusted return
by using historical prices & volume.

Evidence indicate we cant reject the
hypothesis that markets are weak-form
efficient.

TA shown success in EM.

Fundamental Analysis

Event study test shows that developed
markets are generally semi-strong form
efficient however EM are not.

Exceptionally skilled investors can generate
abnormal profit through the use of
fundamental analysis.

Active VS Passive Portfolio Management

Invest passively if markets are semi-strong

and weak-form efficient.

Portfolio manager can add value through
establishing & implementing objectives,
diversification, asset allocation & tax
management.

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2015, Study Session # 13, Reading # 47

47.f

Anomaly deviation from the common rule (an
exception to the notion of ME).

Data mining or data snooping investigating data
until a statistically significant relation is found.

To avoid data mining find economic basis b/w
variables & stock return.

Anomalies in Time-Series Data

Calendar Anomalies

Overreaction & Momentum Anomalies

January effect or turn-of-the year effect during

first five trading days of January stock returns are
higher (espically for small firms).

Possible explanations:

Tax-loss selling (sells losing position in December
& buys in Jan. at higher prices).

Window dressing (sell risky stocks).

Evidence indicates January effect is not persistent.

Other calendar anomalies

Turn-of-the-month effect (returns are
at month
end).

Day-of-the-week effect (avg. Monday returns are
negative).

Weekend effect (Returns over the weekend lower
than weekdays).

Holiday effect pre-holiday returns are higher.

Overreaction Effect

Firms with poor stock returns over previous three to
five years have better returns.

Pattern attributed to investor overreaction to
unexpected good & bad news.

Momentum Effects

High short term returns are followed by continued
high return.

Both, overreaction & momentum effects violate weak
form ME.

Anomalies in Cross-Sectional Data

Size Effect

Value Effect

Small-cap stocks outperform large-cap stocks

(a random result for the time period
examined).

Value stock (low P/E, low P/B &
dividend yield)

outperform the growth stocks (vice versa multiples).

Violates semi-strong form market efficiency.

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2015, Study Session # 13, Reading # 47

47.f

Other Anomalies

Closed-End Investment Fund Discounts

Earnings Surprises

Traded at a large discount to

NAV. (anomaly).

TC would eliminate any profits.

Earnings surprise portion of announced earnings

that was not expected by market.

Positive surprise leads to positive post announcement
return & negative surprise leads to negative return.

Initial Public Offerings

Economic Fundamental

Typically underpriced.

Some believe this is not an anomaly but
result of statistical methodologies.

Stock returns are usually related to economic

fundamental is not evidence of market inefficiency.

Relationship b/w stock returns & prior information
(e.g. dividend yields) is not constant over all time
periods.

Implication for Investors

Bottom line anomalies will likely be

unprofitable (no sound economic basis).

47.g

Behavioral Finance

Loss Aversion
Tendency for investors to be more risk
averse when faced with potential losses &
less risk averse when faced with potential
gains.

Examines investor behavior, its effects

on financial markets, how cognitive
biases may result in anomalies &
whether investors are rational.

Even if investor rationality is viewed as
prerequisite for ME, there may be no
room for profitable arbitrage for any
mispricing.

Investor Overconfidence

Overestimate their ability to value
securities.

Less diversified portfolio holding.

Representativeness
Investors assessing probabilities of
outcomes depending on how similar they
are to the current state.

Mental Accounting
Classify different investments into
separate mental accounts instead of
viewing as a total portfolio.

Conservatism
Information Cascades

Uninformed traders watch the actions
of informed traders when faced with
unclear information.

Herding behavior (similar to
information cascades) trading
occurs in clusters (not necessarily
driven by information)

Investors react slowly to changes.

Disposition Effect
Investors are willing to realize gains
but unwilling to realize losses.

Narrow Framing

Gamblers Fallacy

Investors view events in isolation.

Recent results affect investors estimate

of future probabilities.

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