B.6 Market Efficiency-1-1.pptx

B.6 Market Efficiency-1-1.pptx - 1 Market Efficiency •...

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1 Market Efficiency Information and Prices The Three Forms of Market Efficiency Weak form Random walks and other tests of the weak form Implications for technical analysis Semi-strong form Event studies, active fund performance and other tests Implications for fundamental analysis Strong form Value of inside information Evaluating the Efficient Market Hypothesis
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Venti Market Efficiency 2 Competition as the Source of Efficiency 1. CAPM/APT/Multi-factor models: Investors can profit by identifying securities that are mispriced (lie “off the line”). 2. Competition among investors should drive security returns back to the line. Huge reward if first to “discover” mis-priced securities. 3. Thus these profit opportunities are likely to be rare and short-lived. . How rare? How short-lived? Depends on how efficient markets are. An efficient capital market is one in which stock prices fully reflect available information, so mis-pricings should be rare and quickly disappear.
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Venti Market Efficiency 3 How Quickly Do Security Prices Adjust to New Information? If competition insures that prices reflect existing information, then what happens when new information arrives? Inefficient response (examples) : Hamilton’s proposal to redeem state bonds at face value (under- reaction). Tylenol scare (over-reaction) Efficient response (examples) : NYSE prices adjust immediately to new information. (within seconds for earnings announcements) Death of key executives
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How a Stock Price May Respond to New Information Stock Price -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement Efficient market response to “good news” Overreaction to “good news” with reversion Delayed response to “good news”
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5 Prices become efficient when informed agents buy and sell at P*. Who are these agents? 1. Informed investors Willing to pay the fundamental value for a security 2. Technical Analysts Who are they? What do they do? Analyze patterns in past prices that predict future prices . Rationalized as predicting the behavior of crowds. Examples: Head and shoulders Wave patterns in stock prices: Dow theory (resistance and support), Elliott wave theory, Kondratieff wave theory Filters/ moving average rules How do prices become efficient?
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Venti Market Efficiency 6 2. Technical Analysts (continued) Analysts will always be able to identify trading rules (patterns) ex-post. If pattern is random then useless to predict. If pattern is not random there exists profitable trading rules Trading based on these rules will make prices reflect all available information in past prices. The patterns will go away and future prices will no longer be able to be predicted from past prices. Technical rules will “self- destruct” Investors must be inattentive for rules to work in future.
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