Unit IV: Capital Market and Inefficient Market Hypothesis PDF

Acquired Previous Knowledge Unit I: The Financial System Unit II: Banking Institutions Unit III: Financial Markets Unit IV: Capital Market and Inefficient Market Hypothesis Joycelyn P. Ituriaga, MBA  At the end of the unit, the student can: differe...

Acquired Previous Knowledge Unit I: The Financial System Unit II: Banking Institutions Unit III: Financial Markets Unit IV: Capital Market and Inefficient Market Hypothesis Joycelyn P. Ituriaga, MBA  At the end of the unit, the student can: differentiate efficient market and inefficient market Topic Outline hypothesis; and differentiate the different market analysis and when to use.  Unit IV: Capital Market and Market Hypothesis 1. Efficient Market and Inefficient Market Hypothesis 2. Types of market analysis Topic Outline a.Fundamental Analysis and Technical Analysis b.Top-down and Bottom-up Analysis c. Economic Analysis d.Industry Analysis e.Company Analysis f. Technical Analysis Tools  The market where investment instruments like bonds, equities and mortgages are traded. Capital Market The primary role of this market is to make investment from investors who have surplus funds to the ones who are running a deficit. How can we forecast Fundamental Analysis Technical Analysis price of share? INFORMATION Fundamental Analysis vs. Technical Analysis Fundamental Analysis Technical Analysis Industry Analysis Theories Company Analysis Charting Economic Analysis Moving Averages  An inefficient market is one that fails in INEFFICIENT MARKET incorporating all available information into a true reflection of an asset's fair price. Market inefficiencies exist due to information asymmetries, transaction costs, market psychology, and human emotion, among other reasons. As a result, some assets may be over- or under- valued in the market, creating opportunities for excess profits. The presence of inefficient markets in the world somewhat undermines economic theory, and in particular the efficient market hypothesis (EMH). Why Efficient Market To test the form of market – extent of efficiency. To make sure that one can accurately forecast the market, Hypothesis? discover the market trend and help investors to make critical decisions. The most important consequences of this hypothesis is that it is not possible to outperform the market (adjusted for risk) over the long term What is Efficient Market? A market where there are large numbers of rational profit maximizes actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. Market Reaction to an Unanticipated Favorable Event Market Reaction to Anticipated Favorable Event Monday Effect… Efficient Market Hypothesis Securities prices always fully reflect all available, relevant information about the security. Note the key words of the definition: “always,” “fully,” and “information.” Two important questions What is all available information? What does it mean to “Reflect all available information?” All available information Past Price: Weak Form All public information: Semi-Strong Form Past price, news etc.. All information including inside information: Strong Form Why should price reflect available information? If not, there would be arbitrage opportunities Early thinking about securities market prices th (early 20 century): Observers noticed that the charts that tracked the pattern of stock market prices looked similar to a chart of a random event, such as tossing a coin and making an increase if you get a “heads,” or a decrease if you get a “tails.” They wondered why the stock market behaved like a random walk. Important! The actual stock price was not seen to be random, only the CHANGE in the price appeared to be random in occurrence. In particular, using valuation theory, it should be true that a common stock sells for a price that is the present value of all the future cash flows (dividends) expected by investors. What would cause a stock price to change? A reasonable answer is that the price would change if investors obtain new information about the stock that causes them to revise their forecast about the stock’s future return. New information that causes investors to be more optimistic would cause them to revalue the stock price higher. Negative would result in lower price revaluations. Since new information arrives in the market in an unpredictable (random) fashion, prices will change randomly as well. Conclusion: New information is the cause of securities price changes. Since one cannot predict whether the next piece of information will be favorable or unfavorable for a stock, the future changes in stock prices are similarly unpredictable. Much empirical research has been done to examine how much (or how fully) information is incorporated in market prices. Questions about the extent of the information incorporated has led to several terms to describe the degree of efficiency exhibited in a particular market. The three terms are “weak form efficient,” “semi-strong form efficient,” and “strong- form efficient.” Weak form evidence: Studies show that systems that try to predict the future course of stock prices based upon some rule derived from history (past, days, weeks, or months) of past stock price changes do not make profit greater than a simply buy and hold strategy. Statistical analysis of successive stock price changes reveals that the correlation between price changes is approximately zero. Weak Form If a market is weak from efficient, then technical analysis should not be effective in picking stocks for above average profits. Despite the evidence for market efficiency, there are many professional investors who claim that technical analysis can be effective. Such claims are largely unproven but is shows that not everyone accepts the efficient market hypothesis. The semi-strong form efficient market hypothesis – a definition and some evidence: The semi-strong efficient markets hypothesis maintain that all publicly available information is incorporated in stock prices. Semi-strong evidence: Studies show the public announcements of earnings, dividends, stocks splits, etc. cause stock prices to immediately change to reflect the new information. Studies show that mutual funds ( whose professional managers would be expected to have access to the very best information available) do not consistently outperform the average market indexes. If a market is semi-strong efficient, then picking stocks based on publicly available information, should not yield profits greater than what could be obtained using a simple buy and hold strategy. Evidence of efficient markets has given great impetus to the formation of “Index Funds,” for investors wanting to maximize research costs and trading costs while investing in a mutual fund that closely tracks a given market index. The strong form of the efficient market hypothesis – a definition and some evidence: The strong form of the hypothesis maintains that all information obtainable from any source whatever, is incorporated in market prices. Strong form evidence: Studies show that “inside information” available to corporate insiders or market specialists could be used to earn above average trading profits Yet, remember that using inside information is illegal!. Thus, strong form inefficient markets may not be legally exploited to earn greater than average profits, either.  Money managers cannot consistently outperform. Performance of Average Equity Mutual Funds In conclusion There is evidence that markets are weak form and semi-strong form efficient, but probably not strong form efficient. Yet is must be noted that the tests of efficiency have largely focused on well developed markets in the United States. Foreign markets have been studied less extensively and may exhibit less efficiency. This is especially true of markets in less developed countries sometimes called “emerging” markets). Finally, it should be noted that there is some evidence that contradicts the hypothesis. Some market studies give evidence that the strategy as simple as buying low P/E ratio stocks can result in above average profit. The efficient market hypothesis has not been “proven” however, it is highly regarded tenant in modern finance. If markets are efficient, investors can expect that prices are “fair,” and that the rate of return earned from a diversified portfolio of securities over time will be approximately average for the class of securities. References: Efficient Market Hypothesis (EMH) (slideshare.net), retrieved July 2024 Efficient market hypothesis (slideshare.net), retrieved July 2024 Efficient Market Hypothesis (slideshare.net), retrieved July 2024 End of Presentation Thank you. Unit IV: Capital Market and Inefficient Market Hypothesis Joycelyn P. Ituriaga, MBA