Lecture18 - 1 T OPIC 17 E FFICIENT M ARKETS AND M UTUAL F...

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Unformatted text preview: 1 T OPIC 17 E FFICIENT M ARKETS AND M UTUAL F UNDS Objectives: Be able to define of an efficient market Understand weak-form, semi-strong form, and strong form efficiency and be able to explain where most financial markets fall on this spectrum. Understand what it means to “beat the market” and how to measure whether a trading strategy is beating the market. Know the basics of Mutual Funds and why they are a useful tool for retail investors 2 DEFINING MARKET EFFICIENCY Market Efficiency: If capital markets are efficient, prices today reflect all currently available information. The only way to consistently “beat the market” (obtain a return higher than what is justified by your risk) is to be incredibly lucky. Defining a random walk: • Tomorrow’s price change is independent of what happened to today’s prices. • Consider a simple $100 bet: Flip a coin • if heads you win 5%, • if tails you lose 4% • After 2 flips what are your possible winnings? Seems like a pretty random experiment. Well if we compare the results of this experiment to the returns from the stock market, without any labels, you should have a hard time telling the two apart. 3 Coin Flip Game versus the Value Weighted Returns of NYSE and ASE Stocks 50 100 150 200 250 Value 1 Value 2 • If stock prices behave like a random walk, you cannot predict the future movements of prices using the history of prices. • Clearly, the coin flip experiment is a random experiment and yet stock prices look pretty similar. 4 WEAK FORM EFFICIENCY Weak form market efficiency says that all information from the history of past prices is currently incorporated into today’s price. A random walk would characterize a market that is weak form efficient. What would we expect to see if the markets were weak form efficient? • You can’t consistently beat the market by using the history of stock price data. • In a lot of cases, it seems to be true, but there are exceptions (more on this later) • Technical analysis attempts to exploit weak-form inefficiency by forming trading strategies based on historical stock price and volume data o Most strategies based on technicals don’t beat the market on average o There is, however, one important exception we’ll talk about in a few minutes 5 SEMI-STRONG FORM EFFICIENCY Semi-strong form market efficiency says that all publicly available information is incorporated into today’s prices. Fundamental analysts study the business in which a company is engaged, trying to feel the pulse through the published material about the company and the effect that innovations in the marketplace will have on the companies fortunes. What would semi-strong form market efficiency imply?...
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.

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Lecture18 - 1 T OPIC 17 E FFICIENT M ARKETS AND M UTUAL F...

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