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Lec5 - LECTURE 5 Efficient Market Hypothesis Market...

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AF3316 Investments Shaojun (Shaun) Zhang, Ph.D. ASA School of Accounting and Finance The Hong Kong Polytechnic University LECTURE 5 LECTURE 5 Efficient Market Efficient Market Hypothesis, Hypothesis, Market Anomalies, Market Anomalies, and Behavioral and Behavioral Finance Finance
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5-2 AF3316 Lecture 5 Market Efficiency ° ° Maurice Kendall in 1953 found that he could NOT identify any predictable patterns in stock prices. ° Kendall's results were disturbing to some financial economists. ° Do "animal spirits" drive the market? ° Economists came to reverse their interpretation of Kendall's study.
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5-3 AF3316 Lecture 5 Random Walk and the Efficient Market Hypothesis ° ° A forecast about favorable future earnings performance leads to favorable current price performance, as market participants all try to acquire the shares before the price jumps. ° If prices are bid immediately to fair levels, given all available information, it must be that they increase or decrease only in response to new information. ° "New" information, by definition, must be unpredictable. ° This is the essence of the argument that stock prices should follow a “random walk” .
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5-4 AF3316 Lecture 5 Figure 8.1 Cumulative Abnormal Returns Before Takeover Attempts
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5-5 AF3316 Lecture 5 Figure 8.2 Stock Price Reaction to CNBC Reports
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5-6 AF3316 Lecture 5 Random Walk and the Efficient Market Hypothesis ° ° Far from being a proof of market irrationality, randomly evolving stock prices are the natural consequence of intelligent investors competing to discover relevant information ° Don't confuse randomness in price changes with irrationality in the level of prices ° The notion that stocks already reflect all available information is referred to as the efficient market hypothesis (EMH)
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5-7 AF3316 Lecture 5 Competition Drives Efficiency! ° ° Why should we expect stock prices to reflect "all available information"? ° An investment management fund currently managing a $5 billion portfolio can afford to spend up to $50 million on research that increases the portfolio rate of return by 1 percent per year. (500 MBA's @ $100,000 / year !) ° With so many well-funded and motivated analysts willing to spend considerable resources on research, there will be no easy pickings in the market.
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5-8 AF3316 Lecture 5 Versions of the EMH ° The weak-form hypothesis: stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices and trading volume ° The semistrong-form hypothesis: all publicly available information regarding the prospects of a firm must be reflected already in the stock price. (in addition to past prices and volume, fundamental data on the firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices) ° The strong-form hypothesis: stock prices reflect all information relevant to the firm (including information available only to company insiders)
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5-9 AF3316 Lecture 5 Implications of the EMH for Investment Strategies Technical Analysis
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