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7/25/2019 Challenges to Market Efficiency
http://slidepdf.com/reader/full/challenges-to-market-efficiency 1/22
CHALLENGES TO
MARKET EFFICIENCY
7/25/2019 Challenges to Market Efficiency
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An efcient market is one in which stockprices fully reect available information.
The EMH has implications for investors and
rms.◦ Since information is reected in security prices
uickly! knowin" information when it isreleased does an investor little "ood.
◦ #irms should e$pect to receive the fair valuefor securities that they sell. #irms cannot protfrom foolin" investors in an e%cient market.
A Description of EcientMarkets
7/25/2019 Challenges to Market Efficiency
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&nvestor 'ationality &ndependence of events Arbitra"e
Fon!ations of MarketEcienc"
7/25/2019 Challenges to Market Efficiency
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Stock #rice Reactions
Stock(rice
)*+ ),+ )-+ + -+ ,+ *+
/ays before 0)1 and after 01announcement
E%cient market
response to 2"oodnews3
4verreaction to2"ood news3 with
reversion/elayed
response to2"ood news3
7/25/2019 Challenges to Market Efficiency
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5eak #orm
◦ Security prices reect all historical information.
Semistron" #orm
◦
Security prices reect all publicly availableinformation.
Stron" #orm
◦ Security prices reect all information6public and
private.
$%&% T'e Di(erent T"pes of
Ecienc"
7/25/2019 Challenges to Market Efficiency
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Security prices reect all informationfound in past prices and volume.
&f the weak form of market e%ciencyholds! then technical analysis is of novalue.
Since stock prices only respond to new
information! which by denition arrivesrandomly! stock prices are said to followa random walk.
)eak For* Market Ecienc"
7/25/2019 Challenges to Market Efficiency
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)'" Tec'nica+ Ana+"sis Fai+s
S t o c
k
( r i c e
Tim
&nvestor behavior tends to eliminate anyprot opportunity associated with stock pricepatterns.
&f it were possible tomake bi" moneysimply by ndin" 2thepattern3 in the stockprice movements!everyone would do it!and the prots wouldbe competed away.
Sell
Sell
7uy
7uy
7/25/2019 Challenges to Market Efficiency
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Security prices reect all publiclyavailable information.
(ublicly available informationincludes8◦ Historical price and volume information
◦ (ublished accountin" statements
◦ &nformation found in annual reports
Se*istron, For* MarketEcienc"
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Security prices reect all information6public and private.
Stron" form e%ciency incorporatesweak and semistron" form e%ciency.Stron" form e%ciency says that
anything pertinent to the stock andknown to at least one investor isalready incorporated into thesecurity9s price.
Stron, For* Market Ecienc"
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&nvestors can throw darts to selectstocks.◦
This is almost! but not uite! true.◦ An investor must still decide how risky a portfolio
he wants based on risk aversion and e$pectedreturn.
(rices are random or uncaused.◦ (rices reect information.
◦ The price :HA;<E is driven by new information!which by denition arrives randomly.
)'at t'e EMH Does an! Does
NOT Sa"
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4ne "roup of studies of stron" formmarket e%ciency investi"ates insidertradin".
A number of studies support the viewthat insider tradin" is abnormallyprotable.
Thus! stron" form e%ciency does notseem to be substantiated by theevidence.
T'e Stron, For* of t'e EMH
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:HA==E;<ES
Tradin" strate"ies based on historical priceand volume data have been tested e$tensively!usin" computer pro"rammes. Althou"h the bulk
of the evidence su""ests that such strate"iesare unlikely to be successful! chartists point outthat a computer pro"ramme is >ust thebe"innin". They claim that other sub>ective!
non)uantiable information and analysis arealso needed! and that this sub>ective element isi"nored by the computer pro"rammes?
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The time perspective used in academicstudies can be misleadin". =on")term
variations in share prices may be closer to arandom walk 0i.e. unpredictable1 than areshort)term price movements?
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The EMH assumes that all investors processnew information in the same way to makerational decisions. 5hile some professional
investors representin" lar"e nancialinstitutions may resort to sophisticatedmethods of nancial analysis! it is unlikely thatall investors make decisions on this basis. &t has
been found that most investors! includin"professionals! have developed simpliedtechniues and rules 0heuristics1 which theyapply when makin" investment decisions. Such
heuristics are sub>ectively felt to be rational andmay "ive satisfactory results! "iven the realitiesof the nancial market
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#ollowin" on the above point! it is notunreasonable to assume that all information
may not be used by all investors! or maynot be used by all investors in the sameway. &n this case! there will always beinvestors makin" a prot on the basis of
information. Markets will then be brou"htback towards e%ciency throu"h the tradin"of investors who e$ploit favourable pricedierences?
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&t is hard to know whether all relevantinformation is! in fact! available to all
market participants. As #ischo remarked ina -BC, book8 D4ne of my favourite contrastsis that when the market rises followin" "ood
economic news! it is said to be respondin"
to the news? if it falls! that is e$plained bysayin" that the "ood news had already beendiscounted.D
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A study by Schachter and other academics in 1986
concluded that a share price is a social fact: "The
price of a stock is more than an objective
rationally developed number! it is an opinion an
areate opinion the moment#to#moment
resultant of the evaluation of the community of
investors$ As an opinion stock price is subject to
the same set of social pressures and cultural
influences as any other opinion such as the
evaluation of a %ork of art the preference of apolitical candidate or the popularity and spread of
a fad$"
7/25/2019 Challenges to Market Efficiency
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#irstly! short)term share price and marketmovements appear to be very di%cult! if notimpossible! to predict with any accuracy.
Secondly! the market reacts uickly and sharply to
new information! and most of the academicstudies nd little evidence that the market over)reacts or under)reacts to new information in away that can be protable e$ploited.
Thirdly! if the stock market can be beaten! the wayto do it is at least not obvious! so the implicationis that the market is not "rossly ine%cient.
t'ree ,enera+ co**entsre,ar!in, *arket ecienc"&
7/25/2019 Challenges to Market Efficiency
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'ationality◦ (eople are not always rational.
◦ Many investors fail to diversify! trade too much!and seem to try to ma$imie ta$es by sellin"
winners and holdin" losers.
$%&- T'e .e'a/iora+ C'a++en,e
7/25/2019 Challenges to Market Efficiency
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&ndependent /eviations from 'ationality◦ (sycholo"ists ar"ue that people deviate from
rationality in predictable ways8
'epresentativeness8 drawin" conclusions
from too little data This can lead to bubbles in security
prices.
:onservativism 8 people are too slow in
ad>ustin" their beliefs to new information. Security prices seem to respond too
slowly to earnin"s surprises.
T'e .e'a/iora+ C'a++en,e
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Arbitra"e◦ Suppose that your superior! rational! analysis
shows that company A7: is overpriced.
◦ Arbitra"e would su""est that you should short the
shares.◦ After the rest of the investors come to their senses!
you make money because you were smart enou"hto 2sell hi"h and buy low.3
7ut what if the rest of the investment communitydoesn9t come to their senses in time for you tocover your short positionF
◦ This makes arbitra"e risky.
T'e .e'a/iora+ C'a++en,e
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THANK YO0
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