Chapter 13 - Chapter 13 Market Efficiency Description of...

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Chapter 13 Market Efficiency
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Description of Efficient Capital Markets An efficient capital market is one in which securities’ prices fully reflect available information – called the efficient market hypothesis (EMH). The EMH has implications for investors and firms: 1. Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. 2. Firms should expect to receive the fair value (i.e., the present value) for securities that they sell. Firms cannot profit from fooling investors. 3. Trying to “pick” stocks based on public information is a waste of time. All stocks offer you the fair rate of return based on their risk.
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Reaction of Prices to New Information in Efficient and Inefficient Markets 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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Reaction of Price to New Information in Efficient and Inefficient Markets Stock Price -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement Efficient market response to “bad news” Overreaction to “bad news” with reversion Delayed response to “bad news”
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Types of Market Efficiency Weak Form Security prices reflect all information found in past prices and volume Semi-Strong Form Security prices reflect all publicly available information. Strong Form Security prices reflect all information -- public and private.
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Weak Form Market Efficiency Security prices reflect all information found in past prices and volume. If the weak form of market efficiency holds, technical analysis (i.e., trading based on patterns) is of no value. Often weak-form efficiency is represented as Pt = Pt -1 + Expected return + random error Since stock prices only respond to new information, which by definition arrives randomly, stock prices should follow a random walk .
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Why Technical Analysis Fails in an Efficient Market Stock Price Time Investor behavior tends to eliminate any profit opportunity associated with stock price patterns . If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away. Sell Sell Buy Buy
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Security Prices reflect all publicly available information. Publicly available information includes: -- Historical price and volume information -- Published accounting statements. --
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Chapter 13 - Chapter 13 Market Efficiency Description of...

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