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EFB201 Lecture 2 – Theories of Financial Markets Efficient Markets Hypothesis

EFB201 Lecture 2 – Theories of Financial Markets Efficient Markets Hypothesis Reading – Any introductory finance text chapter on market efficiency e.g “Business Finance” 11th ed. by Peirson, Brown, Easton, Howard and Pinder, chapter 16. Tutorial Questions – From Blackboard Site. Outline

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EFB201 Lecture 2 – Theories of Financial Markets Efficient Markets Hypothesis

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  1. EFB201 Lecture 2 – Theories of Financial Markets Efficient Markets Hypothesis Reading – Any introductory finance text chapter on market efficiency e.g “Business Finance” 11th ed. by Peirson, Brown, Easton, Howard and Pinder, chapter 16. Tutorial Questions – FromBlackboard Site

  2. Outline Definition Levels of Efficiency Evidence of Efficiency Implications of Efficiency Anomalies

  3. EMH - Defined • “price react instantaneously” • “all available information” • “unbiased fashion” An efficient market is a market where prices react instantaneously to all available information in an unbiased fashion OR In an efficient market it is not possible to consistently make an abnormal return

  4. Premises of An Efficient Market A large number of competing profit-maximizing participants analyze and value securities, each independently of the others New information regarding securities comes to the market in a random fashion Profit-maximizing investors cause security prices to adjust rapidly to reflect the effect of new information

  5. Arbitrage • Say BHP Billiton shares are selling in London for $25 and in Australia for $35 • If these prices are correct one could buy in London at $25 and sell in Australia for $35 • Price in London would go up and in Australia down until in equilibrium • This applies to any market which is mispriced • A market in equilibrium is efficient (no arbitrage opportunities left)

  6. Levels of Efficiency • Weak Form Efficiency reflects past prices • Semi-strong Efficiency reflects publicly available information • Strong Form Efficiency reflects all information

  7. Weak Form Efficiency - time series - filter rules - technical indicators Evidence suggests it is very difficult to earn abnormal returns using past price information Information - Past price behavior Trading strategy - Technical analysis Market efficiency test - weak form

  8. Semi Strong Form • Information - published reports and info • Trading strategy - Fundamental analysis • Market efficiency test - semi strong form • event studies (e.g. dividends, splits, earnings, takeovers etc) • Profitability of trading on public information Evidence suggests it is difficult toearn abnormal returns using publicly available information

  9. Strong Form • Information - non public, new, monopoly • Trading strategy - private information analysis • Market efficiency test - strong form tests • inside trading • mutual funds Evidence suggests it is possible to make abnormal returns

  10. Misconceptions about Market Efficiency • cannot make a profit • market does not make mistakes • sharemarket is irrational • not possible to make abnormal profits

  11. Implications • Technical Analyst • Fundamental Analyst • Portfolio Manager • Ordinary Investor • Inside Trader • Manager of a firm

  12. Anomalies • January Effect • Size Effect • Book to Market • Behavioural Finance

  13. Summary Your view on market efficiency affects your attitude to investing and your view of financial markets Evidence across many financial markets and different time periods can be conflicting Broad conclusions on market efficiency are that most markets are reasonably efficient at the weak and semi-strong form level, but are not strong form Efficient Some final thoughts

  14. Richard Roll, a portfolio fund manager as well as an academic I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive device that academics have dreamed up… I have attempted to exploit the so-called year-end anomalies and a whole variety of strategies supposedly documented by academic research. And I have yet to make a nickel on any of these supposed market inefficiencies... A true market inefficiency ought to be an exploitable opportunity. If there’s nothing that investors can exploit in a systematic way, time in and time out, then it is very hard to say that information is not being incorporated into stock prices.25

  15. Warren Buffet Somewhat tongue-in-cheek, Warren Buffet has even suggested that to preserve the advantage of having opponents who have been taught not to try, value investors should endow chairs in efficient market theory to perpetuate its teaching

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