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    Chapter 6 Are Financial Markets Efficient

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    Jay Ann Dome
    The document discusses the efficient market hypothesis which states that current stock prices reflect all available information such that prices adjust quickly to new information, eliminating opportunities for arbitrage profits. Evidence in favor of market efficiency includes studies finding investment analysts do not consistently outperform markets and stock prices adjust rapidly to new information. However, some evidence contradicts efficiency, such as small stocks earning higher returns and seasonal stock price patterns.

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    Chapter 6 Are Financial Markets Efficient

    Uploaded by

    Jay Ann Dome
    62 views12 pages
    The document discusses the efficient market hypothesis which states that current stock prices reflect all available information such that prices adjust quickly to new information, eliminating opportunities for arbitrage profits. Evidence in favor of market efficiency includes studies finding investment analysts do not consistently outperform markets and stock prices adjust rapidly to new information. However, some evidence contradicts efficiency, such as small stocks earning higher returns and seasonal stock price patterns.

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    The document discusses the efficient market hypothesis which states that current stock prices reflect all available information such that prices adjust quickly to new information, eliminating opportunities for arbitrage profits. Evidence in favor of market efficiency includes studies finding investment analysts do not consistently outperform markets and stock prices adjust rapidly to new information. However, some evidence contradicts efficiency, such as small stocks earning higher returns and seasonal stock price patterns.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    62 views12 pages

    Chapter 6 Are Financial Markets Efficient

    Uploaded by

    Jay Ann Dome
    The document discusses the efficient market hypothesis which states that current stock prices reflect all available information such that prices adjust quickly to new information, eliminating opportunities for arbitrage profits. Evidence in favor of market efficiency includes studies finding investment analysts do not consistently outperform markets and stock prices adjust rapidly to new information. However, some evidence contradicts efficiency, such as small stocks earning higher returns and seasonal stock price patterns.

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    © All Rights Reserved
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    You are on page 1of 12

    CHAPTER 6:

    ARE FINANCIAL MARKETS


    EFFICIENT?
    THE EFFICIENT MARKET HYPOTHESIS
    • Views expectations as equal to optimal forecasts using all
    available information.
    • An optimal forecast is the best guess of the future using all
    available information. This does not mean that the forecast is
    perfectly accurate, but only that it is the best possible given the
    available information.
    • Implies that the expected return on the security will equal the
    optimal forecast of the return.
    • Current prices in a financial market will be set so
    that the optimal forecast of a security’s return
    using all available information equals the
    security’s equilibrium return.
    • The concept of ARBITRAGE, in which market participants (arbitrageurs)
    eliminate unexploited profit opportunities, meaning returns on a security
    that are larger than what is justified by the characteristics of that security.

    • PURE ARBITRAGE, in which the elimination of unexploited profit


    opportunities involves no risk, and
    • The type of arbitrage in which the arbitrageur takes on some risk when
    eliminating the unexploited profit opportunities.
    IN AN EFFICIENT MARKET, ALL UNEXPLOITED PROFIT
    OPPORTUNITIES WILL BE ELIMINATED.
    • Not everyone in a financial market must be well
    informed about a security for its price to be driven
    to the point at which the efficient market
    condition holds.
    EVIDENCE IN FAVOR OF MARKET EFFICIENCY

    • 1. Performance of Investment Analysts and Mutual


    Funds- when purchasing a security, you cannot expect to
    earn an abnormally high return, a return greater than the
    equilibrium return.
    Having performed well in the past does not indicate
    that an investment adviser or a mutual fund will
    perform well in the future.
    2. Do Stock Prices Reflect Publicly Available
    Information?
    Favorable earnings announcements or
    announcements of stock splits (a division of a share of
    stock into multiple shares, which
    is usually followed by higher earnings) do not, on
    average, cause stock prices to rise.
    3. Random-walk Behavior of Stock Prices

    • Describes the movements of a variable whose future


    changes cannot be predicted (are random) because, given
    today’s value, the variable is just as likely to fall as to rise.
    Future changes in stock prices should, for all practical
    purposes, be unpredictable.
    • 4. Technical Analysis- studies past stock price data and
    search for patterns such as trends and regular cycles.

    Past stock price data cannot help predict changes.


    Therefore, technical analysis, which relies on such data
    to produce its forecasts, cannot successfully predict
    changes in stock prices.
    EVIDENCE AGAINST MARKET EFFICIENCY
    • 1. Small-Firm Effect- small firms have earned
    abnormally high returns over long periods of time, even
    when the greater risk for these firms has been taken into
    account.
    May be due to rebalancing of portfolios by institutional
    investors, tax issues, low liquidity of small-firm stocks,
    large information costs in evaluating small firms, or an
    inappropriate measurement of risk for small-firm stocks.
    2. January Effect- stock prices have tended to experience an
    abnormal price rise from December to January that is
    predictable and hence inconsistent with random-walk behavior.
    • due to tax issues
    • 3. Market Overreaction- an investor could earn abnormally
    high returns, on average, by buying a stock immediately after
    a poor earnings announcement and then selling it after a
    couple of weeks when it has risen back to normal levels.
    4. Excessive Volatility- fluctuations in stock prices may be
    much greater than is warranted by fluctuations in their
    fundamental value.
    5. Mean Reversion- Stocks with low returns today tend to
    have high returns in the future, and vice versa.
    6. New Information Is Not Always Immediately
    Incorporated into Stock Prices

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