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Similar to Market efficiency (20)
Market efficiency
- 1. Question 04: We all know that investors have widely diverse opinions about the future course of the economy and earnings forecasts for various industries and companies. How then it is possible for all these investors to arrive at an equilibrium price for any particular security? Answer: • The supply and demand for securities will determine an equilibrium price of securities therefore the expected price of stocks will be given by the market equilibrium. Stock price are a function of supply and demand. Market forces, known as supply and demand, play a significant role in the determination of price. Understanding the basics of economics can assist an investor in two ways: 1. The stock investor is able to make an educated assessment of where the economy and financial markets are in the current economic cycle. And therefore, which asset classes will most likely offer the greatest return, 2. The stock investor (and trader) will be better placed to understand which side of the market is driving a stock’s price. For example, is it the supply side or underlying demand that is currently moving a stock’s price? Equilibrium Price The fundamental principle of economics states that the actual quantity of an item demanded and supplied is determined by the intersection of the supply and demand curves. The price at which the supply and demand curves intersect is known as the equilibrium price figure 1. At this price, the market is said to be in a state of equilibrium (i.e. in balance). Any changes in the non-price factors influencing supply or demand will disturb the equilibrium by shifting the supply or demand curve either up or down. Fig 1: Equilibrium Price ID- 120350
- 2. When this occurs, market forces quickly bring supply and demand back into balance and a new equilibrium point is established. A common example demonstrating the effects of a market in disequilibrium (imbalance) is when a stock price suddenly ‘breaks out’ of a trading range (area of price equilibrium) and moves higher (or lower) on heavy volume. An increase in supply will lead to a fall in price (as supply exceeds demand). Whilst, an increase in demand will lead to a rise in price (as demand exceeds supply). The change in supply or demand causes an imbalance which is reflected as a change in a stock’s price. This change creates a trading or investment opportunity from a technical analysis perspective. In summary, what we have briefly explored here is the interaction of supply, demand, and price. This is a concept that every investor (and trader) should strive to comprehend. It is a concept that is revisited day-in and day-out in the stock market. It is the underlying principle behind identifying a profitable, future trade or investment. Question 05: Distinguish between the three forms of market efficiency. Answer: Market efficiency: Market efficiency is as "one in which prices always fully reflects available information”. The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources. Allocatonally efficient market is one in which the firm with the most promising investment opportunities have access to the needed fund.in other word, efficient market is defined as one in which every securities’ price equals its investment at all time. There are 3 types of market efficiency- 1. Weak-form of efficient market 2. Semi strong efficient market 3. Strong form of efficient market Weak-form efficiency In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of analysis may still provide excess returns. This implies that future price movements are determined entirely by
- 3. information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EM does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market 'inefficiencies'. However, while EM predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer and that, moreover, there is a positive correlation between degree of trending and length of time period studied . Weak Form Tests The tests of the weak form of the EM can be categorized as: 1. Statistical Tests for Independence - In our discussion on the weak-form EM, we stated that the weak-form EM assumes that the rates of return on the market are independent. Given that assumption, the tests used to examine the weak form of the EMH test for the independence assumption. 2. Trading Tests - Another point we discussed regarding the weak-form EM is that past returns are not indicative of future results, therefore, the rules that traders follow are invalid. Semi-strong-form efficiency In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information. Semi-strong Form Tests Given that the semi-strong form implies that the market is reflective of all publicly available information, the tests of the semi-strong form of the EM are as follows: 1. Event Tests - The semi-strong form assumes that the market is reflective of all publicly available information. An event test analyzes the security both before and after an event, such as earnings. 2. Regression/Time Series Tests - Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.
- 4. Strong-form efficiency In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information. Strong-Form Tests Given that the strong-form implies that the market is reflective of all information, both public and private, the tests for the strong-form center around groups of investors with excess information. These investors are as follows: 1. Insiders - Insiders to a company, such as senior managers, have access to inside information. SEC regulations forbid insiders for using this information to achieve abnormal returns. 2. Exchange Specialists - An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that exchange specialists can achieve above average returns with this specific order information. 3. Analysts - The equity analyst has been an interesting test. It analyzes whether an analyst's opinion can help an investor achieve above average returns. Analysts do typically cause movements in the equities they focus on. 4. Institutional money managers - Institutional money managers, working for mutual funds, pensions and other types of institutional accounts, have been found to have typically not perform above the overall market benchmark on a consistent basis.
- 5. Question 11: Although security markets may not be perfectly efficient, what is the rationale for expecting them to be highly efficient? Answer: A market is efficient when security prices reflect all the available information. Under ideal conditions, information is free and investors have the opportunity to take advantage of available information and make rational decisions about securities prices in the market. Under non-ideal conditions, information is not free and investors have to do cost benefit analysis in order to decide how much information they acquire to make rational decisions. Rationale for highly efficient market: The following rationales are the features of an efficient market- Efficient system to facilitate trading- A good market should operate smoothly and efficiently in terms of operation. Buyers and sellers should be able to meet their expectations without any time delays or difficulties. Strong-form market efficiency Semi-strong-form market efficiency Weak-form market efficiency It is the most satisfying and compelling form of EMH in a theoretical sense It is difficult to confirm empirically If a market is strong-form efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all relevant information, whether the information is in the public domain or not. It says that the market will quickly digest the publication of relevant new information by moving the price to a new equilibrium level It is less difficult to test than the strong form. One problem with the semi- strong form lies with the identification of ‘relevant publicly available information’. ‘New’ information must by definition be unrelated to previous information; otherwise it would not be new. Every movement in the share price in response to new information cannot be predicted from the last movement or price The development of the price assumes the characteristics of the random walk ,
- 6. Availability of information- Timely information plays a vital role in decision-making relating to investments in stocks. Information on share prices, volumes and bids of transactions should be available on time without any difficulty. Liquidity- Liquidity in this context refers to the ability to buy or sell shares quickly at a known price that is not substantially different from the price a moment ago. Transaction Cost- An efficient market should be cost effective to the investors. In other words, transaction cost should be minimal. The transaction cost includes brokerage, cost of trading in the market and cost of transferring the ownership of the stock. Information Processing Efficiency- One of the most critical and important attributes of a good market is its information processing capability. The market price should adequately reflect all information relating to the stock. This also means that the market should swiftly adjust prices to new information relating to stocks When new information enters the securities market, prices will adjust quickly because investors will revise their prior beliefs. They will start selling and buying securities based on their new beliefs and this will cause changes in prices. It means that market prices are relative to publicly available information. Fluctuation in the market is expected due to the seasonal nature of business, or retirement of key employees, etc. The time series in which a particular securities price has random fluctuations, over a period of time, is called random walk. Question 12: When a corporation announces it’s earning for a period, the volume of transaction in its stock market may increase, but frequently that increase is not associated with significant moves in the price of its market. How can this situation be explained? Answer: There is always some risk associated with the stock market. So you should be always aware of the risk that is involved in the market. There are investors who make money in the stock money by buying stocks at a cheap price and then selling it off in a much higher rate. There are some forces that move stock prices. So let us have a look at the factors that influence the movements of the stock prices: Have the latest information: You need to have the latest updates of the stock market if you wish to get profits from the investments that you have made in the market. The information that you get is based on the data that the public is aware of.
- 7. About inflation: inflation is another factor that decides the forces moving the stock prices. There is a record that had been a strong inverse correlation between valuation and high inflation. If you fail to understand the concepts of inflation and deflation in the market then you need to study very well about the market as these are the basics of the stock market and the economy as well. Economic strength: As you know that company stocks have the tendency to keep track with the market. There is a lot of leading investments firms that has got lots of importance to the overall market and there are also major factors that are involved in the movement of the prices. So it is always important that you know every aspects of the working of the stock market .you should know how to deal with different stocks in the market. Psychological issues: People have become very greedy and they tend to invest all their money in the stock market. There are also investors who are greatly influenced by their friends and relatives. So they invest their money in the market without having any knowledge of the working of the stock market. So sometimes this may cause a very bad impact on the investors who lose all their money investing in the wrong as well as bad stocks. Uncertainty: It is quite uncertain about your profits or losses in the stock market. So the movement of the prices of stocks is also affected by a vague future. There is an unpredictable future in the stock market. You can never know whether you are going to make huge income or incur big losses in the stock market when you invest in the market. So there is always an amount of uncertainty when it comes to your profit or losses in the stock market. Question 16 : In perfectly efficient markets with transaction costs, why should analysts be able to find mispriced securities? Answer: In a world where it costs money to analyze securities, analysts will be able to identify mispriced securities. Mispricing occurs because of the brokerage industry and the mentality of those in the industry. The mispricing occurs because of a downgrade of the stock. At the top of bull markets the analysts have a majority of buy ratings out on the stocks and during the trough of bear markets the analysts have a majority of sell ratings on the stocks. The following are the main assumptions for a market to be efficient: A large number of investors analyze and value securities for profit. New information comes to the market independent from other news and in a random fashion.
- 8. Stock prices adjust quickly to new information. Stock prices should reflect all available information. Securities can be mispriced by two ways: Overvalued Undervalued Transaction cost: The cost associated with exchange of goods or services and incurred in overcoming market imperfections. Transaction costs cover a wide range: communication charges, legal fees, informational cost of finding the price, quality, and durability, etc., and may also include transportation costs. In reality, the brokerage firms make your job of finding mispriced stocks even easier. They generally tend to downgrade stocks after their stock price has already been beaten up. Subsequent to the downgrade, the stock price drops even further, providing you with a greater margin of safety then before the downgrade. What a gift! Institutional investors are another great place to look for reasons as to why a stock might be mispriced. Institutional investors are the big Mutual Funds and Pension Funds that run billions of dollars. These guys are invested in every sector and tend to use asset allocation and as a consequence pay very little attention to the fundamentals of the individual company they are invested in. One reason an Institution might sell a stock is that they are allocating more funds to a different industry and need to sell stock to obtain capital. Another reason could be that the Institution is having redemptions. (Investors in fund pulling out their money) The fund is forced to liquidate some of their positions in order to pay back their investors. There are countless other reasons why a stock might get mispriced. Just remember to do your research and try and figure out an estimate of what a particular company is worth. When the stock falls well below that value it is generally a great time to buy that stock. However, their gain from doing so well be exactly off-set by the increased costs (perhaps associated with the money needed to procure data and analytical software) that they incur. Hence, their gross returns will indicate that they have made abnormal returns, but their net returns will show that they have earned a fair return and nothing more. Of course, they can earn less than a fair return in such an environment if they fail to properly use the data. For example, by rapidly buying and selling securities, they may generate large transactions costs that would more than offset the value of their superior analysis.
- 9. In efficient markets, the price of a security is fully informative; it fully reflects all available information of that security. Since information gathering is costly, and investors could not expect to beat the market, they will not be motivated to gather information. The logical inconsistency is this: if prices fully reflect available information, investors will not gather information; hence, prices will not fully reflect available information. The potential implication of this inconsistency is that financial statements may not be useful to investors. The inconsistency is avoided because of the presence of liquidity traders or noise traders. These types of investors are irrational and make buy/sell decisions at random. As a result, share prices are only partially informative as they are now mispriced. Rational investors can gather more information about securities by carefully analyzing financial statements. Hence, financial statements are useful to investors.