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Chapter 10 Questions
What do we mean when we say that capital markets are efficient? Why should capital markets be efficient? What factors contribute to an efficient market? Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each of them?
Chapter 10 Questions
How does one test the three efficient market subhypotheses, and what are the results of the tests? For each set of tests, which results support the EMH and which indicate an anomaly related to the hypothesis? What are the implications of the results for stock strategies and portfolio managers? What is the evidence related to the EMH for markets in foreign countries?
Under these conditions, a securitys price would be appropriate for its level of risk.
Weak-Form EMH
Current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information This implies that past rates of return and other market data should have no relationship with future rates of return
Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
Strong-Form EMH
Stock prices fully reflect all information from public and private sources This would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case) Implication: Not even insiders would be able to beat the market on a consistent basis
Runs tests
Indicate randomness in prices
Reality Check!
If someone writes a book on how to beat the market, you can bet that book sales are more lucrative than the trading strategy! Even if it once worked, if its widely known, it wont work any more! Dont quit your day job to trade on-line using a published strategy!
Price-earnings/Growth ratios
Mixed results
Although various measures including the P/E ratio seem to help predict future returns, the size effect and BV/MV ratio have the greatest predictive ability.
Corporate events
Prices react quickly to announcements of mergers, financing decisions, etc. No systematic profit opportunities
Later studies indicate that insiders may no longer be able to generate abnormal returns
There is some evidence of superior analysts who apparently posses private information
Behavioral Finance
A growing field of study in finance. Rather than assuming ultra-rational behavior, the area of behavioral finance seeks to incorporate how humans actually behave.
Incorporates the ways in which psychology may impact investment decisions It has been useful for explaining various anomalies that we observe in decision-making that are difficult to reconcile with rationality
Behavioral Finance
Using psychological biases to explain behavior
Why do investors persistently ride losers and sell winners?
Can be explained by prospect theory
In an efficient market, prices already reflect public information, so determining intrinsic value using that information is not a worthwhile exercise