Chapter 9 APFM.docx

Chapter 9: In an efficient market, all relevant information is instantly and accurately reflected in prices. Hence, no piece of information can be used by a trader to make a profit when prices adjust instantly. All securities are fairly valued at all times. Jensen’s Definition of Efficiency Malkiel’...

Chapter 9: In an efficient market, all relevant information is instantly and accurately reflected in prices. Hence, no piece of information can be used by a trader to make a profit when prices adjust instantly. All securities are fairly valued at all times. Jensen’s Definition of Efficiency Malkiel’s Definition of Efficiency A market is said to be informationally efficient with respect to an information set 𝝮, if an investor cannot make economic profits (risk-adjusted returns net of all costs) by trading on the information contained in 𝝮 𝝮 comprises all the pieces of information that the investor is using to try to earn excess returns A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. The market is said to be efficient with respect to some information set, 𝝮, if security prices would be unaffected by revealing that information to all participants Both definitions require that in an efficient market, a specified set of information cannot be used to make a trading decision that delivers positive economic profits. In other words, the information set cannot be used to forecast excess returns. Hence, it is impossible to tell which securities will deliver returns above or below their required returns in an efficient market. However, Shleifer (2000) argues that any one of the conditions stated below should lead to efficiency: Rationality: All investors are rational, receive information in a timely fashion and process it quickly. Thus, all investors adjust stock valuations in the same way when news arrives and prices adjust instantly. Independent deviations from rationality: If not all people are rational, but optimists and pessimists have equal influence on markers, then their irrationality will balance out and stocks will be fairly priced. Dominance of rational, professional investors: If there is a large group of investors (maybe working in banks and funds) who are rational and have a great amount of money to invest, then when they see the prices that are ‘wrong’, they trade and their trading will push the prices to the ‘right’ level. Based on the different definitions of efficiency stated above, 3 factors are left unspecified: Information set 𝝮: 𝝮 details which pieces of information we are using to try to forecast returns on securities Definition of risk and the returns: To discover whether a portfolio generates profits, one has to find out whether the returns that a portfolio should deliver are due to its risk Trading Costs: There must be accountability for the costs of forming and rebalancing that portfolio in terms of trading cost to say that the portfolio generates profit Information Sets: Roberts (1967) came up with a set of classifications for the different choices of information set to categorise the efficiency level Variety Information Set Weak-form Past prices Semi-strong form All public information Strong form All public and private information To assess whether a stock market is efficient, one needs to understand whether genuine economic trading profits can be made. This requires us to compute excess or abnormal returns which, in turn, requires an asset pricing model. If CAPM is the asset pricing model, a security’s expected excess return is the CAPM 𝜶: Problem: Joint Hypothesis Problem Conducting a test of efficiency requires us to use an asset pricing model to calculate abnormal returns. However, in the previous example, CAPM was used, it may not be the case for every example. The immediate implication is that all tests of efficiency are a test of a joint hypothesis containing 2 parts; 1. The market under analysis is informationally efficient, 2. The researcher knows and uses the correct asset pricing model to generate abnormal returns. If we reject the null hypothesis, it can be because either (or both) of the parts of the hypotheses are invalid. This creates uncertainty when interpreting any test results Since new information is by definition unpredictable, any price changes based on this new information will be unpredictable. However, the unpredictability of future (risk-adjusted) risks does not imply that there is no relationship between stock prices and fundamental variables like dividends or earnings. Increased dividend payments can lead to increased stock prices, but in an efficient market, stock prices adjust instantly to news of increased dividends such that returns are still impossible to forecast. There are 2 statistical/econometric methods that some researchers have used to study certain forms of efficiency: Autocorrelations It can be used to test the proposition that future (abnormal) returns are unrelated to the current and past (abnormal) returns. Event Studies It directly looks at price (or cumulative abnormal return) reactions to specific types of corporate (or economic) event There are some of the more important violations of efficiency that have been uncovered in stock (and bond and FX) market data. Post-earnings announcement drift Using the Event Studies techniques, researchers have found that markets don’t react perfectly efficiently to the news in earnings announcements. Portfolios of stocks that have released unexpectedly good earnings news deliver much greater average abnormal returns than portfolios of stocks that have released unexpectedly bad earnings. New issue puzzle Companies who issue shares to the public for the first time through IPO or issue more, new shares to the public (through a seasoned equity offering) underperform firms who do not issue shares for a period of up to 5 years after the date of issue. Momentum A strategy of buying stocks that have delivered positive returns in 12 months up to the present and selling stocks that have delivered negative returns in the year to the present day delivers, on average, significant positive returns. These returns seem to be present across time, countries and asset classes. However, it is not common and it is very hard to consistently profit from security mispricing because the consistent, identifiable violations of efficiency are so rare.