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Chapter 8

Chapter 8. Random Walks and Efficient Markets. Learning Goals. What is Random walk What is Efficient Market Hypothesis (EMH) Differentiate between the levels of Market efficiency. Introduction.

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Chapter 8

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  1. Chapter 8 Random Walks and Efficient Markets

  2. Learning Goals • What is Random walk • What is Efficient Market Hypothesis (EMH) • Differentiate between the levels of Market efficiency.

  3. Introduction • Efficient Market Hypothesis (EMH), formally presented by Eugene Fama (1970), asserts that financial asset prices fully reflect all available, relevant information. • Implicit in this assertion is the idea that financial asset prices reflect all relevant historical and current information, and that they incorporate every piece of forecastable information into unbiased forecast of future prices.

  4. EMH conclude that: • Securities are rarely, if ever, substantially mispriced in the marketplace • No security analysis, however detailed, is capable of identifying mispriced securities with a frequency greater than that, which might be expected by random chance alone.

  5. Random Walks Hypothesis • Random Walk: the theory that stock price movements are unpredictable, so there is no way to know where prices are headed • Studies of stock price movements indicate that they do not move in neat patterns • This could be an indication that markets are highly efficient and respond quickly to changes in the current situation

  6. Random Walks Hypothesis • Random Walk: the theory that stock price movements are unpredictable, so there is no way to know where prices are headed • Studies of stock price movements indicate that they do not move in neat patterns • This could be an indication that markets are highly efficient and respond quickly to changes in the current situation

  7. Efficient Markets • Efficient Market: a market in which securities reflect all possible information quickly and accurately • Efficient Market Hypothesis: markets have a large number of knowledgeable investors who react quickly to new information, causing securities prices to adjust quickly and accurately

  8. To have an efficient market, you must have: • Many knowledgeable investors active in analyzing and trading stocks • Information is widely available to all investors and is free/easy to obtain • Events, such as labor strikes or accidents, tend to happen randomly • Investors react quickly and accurately to new information, causing prices to adjust

  9. Levels of Efficient Markets • Weak Form • Past data on stock prices are of no use in predicting future stock price changes • Everything is random • Should simply use a “buy-and-hold” strategy • Semi-strong Form • Abnormally large profits cannot be consistently earned using public information • Any price anomalies are quickly found out and the stock market adjusts

  10. Strong Form • There is no information, public or private, that allows investors to consistently earn abnormally high returns

  11. Behavioral Finance • Often a seeming refutation of the efficient market theory may instead be a refutation of the asset-pricing model (that is Beta the only measure of risk and return). • Behavioral finance theorist found that several unexplainable anomalies have been identified that gives an impact on security’s return which is call market anomalies

  12. Market Anomalies • P/E Effect • Uses P/E ratio to value stocks • Low P/E stocks may outperform high P/E stocks, even after adjusting for risk • Small-Firm Effect • Size of a firm impacts stock returns • Small firms may offer higher returns than larger firms, even after adjusting for risk • Neglected-firm effect • The tendency of investment in stock of less well-known firm to generate abnormal return

  13. Book-to-market effect • The tendency for investment in shares of firms with high ratios of book value to market value to generate abnormal returns. • Reversal effect • The tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period. • Calendar Effects • Stocks returns may be closely tied to the time of year or time of week • Questionable if really provide opportunity • Examples: January effect, weekend effect

  14. Earnings Announcements • Stock price adjustments may continue after earnings adjustments have been announced • Unusually good quarterly earnings reports may signal buying opportunity

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