Market efficiency definitions (I)

Transcription

1 Market efficiency definitions (I) 1. In an efficient market, prices reveal information fully and immediately. True or false? No, due to information processing costs and frictions, we can not observe a fully revealing equilibrium, neither prices can react instantaneously. 2. Predicting prices is costly. What are the costs? Information is not accessible by everyone and is not free. Either you have to pay for it or produce it (which is again costly due to salaires, rents, and cost of other means to access information). Furthermore, to execute a strategy based on information you have to bear transaction costs each time you buy/sell assets. 3. The fact that prices are predictable implies that markets are not efficient True or false? No, actually this is not the right question to ask. The more important question is: Are the profits related with forecasts enough to cover costs associated with the forecast? 1 Lex Diapo suite < < > Menu

2 Market efficiency definitions (II) 4. An informationally efficient market is necessarily an allocationally efficient market. True or false? No. The observed prices and informational (fundamental) value of the asset can be considerably different in an efficient market. Informational efficiency is about nonpredictability of this difference not how big the difference is. 5. Who first established the existence of a linkage between prices and information? Hayek (1945, The Use of Knowledge in Society). We must look at the price system as such a mechanism for communicating information. 6. Suppose there exist significant statistical dependencies between successive prices. Does the existence of such dependencies imply that markets are inefficient? No. You have to test whether this statistical dependency is practically exploitable. One needs to take into account frictions such as transaction costs or costs associated with running an actively managed portfolio. 2 Lex Diapo suite < < > Menu

3 Speed of adjustment (20-2) 1. How long does it take for prices to adjust on an efficient market? The delay should be such that one should not be able to make a profit from the information disseminated. 2. Assuming fully-revealing equilibrium, how long does it take for prices to adjust to new information? With no delay. 3 Lex Diapo suite < < > Menu

4 Expectations and market efficiency (20-3) 1. Assume an investor has rational expectations. For him, today s price is the best predictor of tomorrow s price. True or false? No. Only under naive expectations. 2. Do rational expectations allow to account for other agents expected behavior? If yes, how? Yes. This is actually captured by the information set I t. Taking a conditional expectation impicitly accounts for other agents expectations. 4 Lex Diapo suite < < > Menu

5 Cours BPA Consensus (20-5) 1. On this graph, EPS forecasts are formulated in year 2000 about year 1999 (which ends on December 1999). Howcome? 2. The consensus is computed as the arithmetic average of the various analyst forecasts. Is this weighting scheme optimal? Avl Mai Jun Jut Aût Sep Oct Nov Déc Jan Fév Mrs Avl Mai Jun Jut Aût Sep Oct Nov Déc Jan Fév Mrs Lex Diapo suite < < > Menu

6 Consensus (20-5) 1. At the end of accounting year, accounting data is still not public. Accounting figures are published with a lag. Furthermore, there are still several accounting adjustments made even after the data are published (for example on the way earnings were calculated, depreciation methods used, tax carryforwards, backwards, etc.). 2. Arithmetic average gives the same weight to every analyst. However, certain analysts can be more credible than the others. For example, if an analyst revises his forecast systematically after the others by copying them, his forecast will appear with a gap affecting the average consensus. Value-weighted averages (where analyst are weighted with respect to their creditworthiness) can prove to be more effective in such cases. 6 Lex suite < < >

7 o EXTRA questions State which of the following is inconsistent with an efficient capital market, the CAPM, or both: a) A security with only diversifiable risk has expected return that exceeds the risk-free interest rate This statement is inconsistent with both. Only diversifiable risk implies no indiversifiable (market) risk. Thus, according to CAPM this is a zero-beta security, which is expected to earn the risk-free rate. Hence inconsistent with CAPM. It is a security above the SML hence underpriced. In an efficient market, savy investors would buy the stock pushing its price up, lowering its return. In equilibrium, the expected return of this stock should match its required return, i.e. the risk-free rate. If this is not the case, the markets are not efficient. 7 Lex suite < < >

8 b) A security with a beta of 1 had an excess return of 15% last year when the market excess return in the same year was 9%. This statement is consistent (or is not inconsistent) with both Realized returns might differ from expected returns due to continuous arrival of new information. If during the year, there were good news (i.e. earnings surprises) about the stock, investors could have incorporated this info. into prices, implying higher than expected returns for the year. c) A small stock with a beta of 1.5 tend to have higher returns on average than a large stock with a beta of 1.5 This statement is inconsistent with CAPM but not necessarily inconsistent with efficient markets Beta might not be the correct specification for risk. Small firms might be riskier due to other sources of risk factors (i.e. volatility risk, liquidity risk, business cycle risk etc.), therefore investors might require higher returns for small stocks taking into account those risk factors 8 Lex suite < < >

9 Describe the three forms of efficiency and give an example of each Weak: The market price of an asset reflects all information contained in the history of past prices - you cannot beat the market by merely analysing past prices. Semi-strong: The market price of an asset reflects all relevant publicly available information - you cannot beat the market by trading on publicly known information. Strong: The market price of an asset reflects all relevant information, both public and private you cannot beat the market even if you have access to privileged information. 9 Lex suite < < >