equity 3: Market efficiency

What is an informationally efficient market?

• asset prices reflect new information quickly and rationally.

• etermines whether consistent superior risk-adjusted returns are achievable and whether active or passive strategies are preferable.

when to use passive / active strategies?

efficient: passive as active cannot get superior returns after costs

inefficient: active → mispricing opportunities

What type of information should prices react to in an efficient market?

Only the unexpected (surprise) component of new information.

What is market value?

The current price at which an asset can be bought or sold.

• determined by supply and demand.

What is intrinsic value?

estimated value based on full understanding of an asset’s fundamentals and risk.

• include cash flow size, timing, and risk.

What creates opportunities for active investors?

• Mispricing occurs when market value ≠ intrinsic value.

• Active investors aim to buy undervalued assets and sell overvalued assets.

• Efficient markets reduce or eliminate persistent mispricing.

How does the number of market participants affect efficiency?

More participants generally increase market efficiency because information is processed faster.

• small cap less efficient

• opening to foreign investors makes it more efficient

How does information availability affect market efficiency?

Greater availability improves efficiency because more investors can process information quickly.

• developed markets most efficient

Why do insider trading laws improve efficiency?

promote fairness and increase investor participation in markets.

• e.g. Regulation FD (Fair Disclosure)

  • A rule requiring firms to disclose material nonpublic information to all investors simultaneously.

How does arbitrage affect market efficiency?

improves efficiency by eliminating price differences across markets.

• Buy undervalued assets and sell overvalued ones.

• This pushes prices toward equilibrium.

What limits arbitrage?

trading frictions such as execution delays, high costs, and lack of transparency.

How do transaction costs affect market efficiency?

create “bounds” where small mispricings may persist because arbitrage is not profitable.

• markets are still considered efficient if small mispricing exists if exploiting them is not profitable after transaction costs.

What does Grossman and Stiglitz’s idea imply?

Markets cannot be perfectly efficient because investors must be rewarded for gathering information.

What is the modern view of market efficiency?

Profit must remain after accounting for risk and all trading costs.

What is the Efficient Market Hypothesis (EMH) and who developed it?

A theory stating that security prices fully reflect all available information at any point in time.

Eugene Fama.

What are the three forms of market efficiency and do they use past market data, public information or private information?

Forms of Market Efficiency	Past Market Data	Public Information	Private Information
Weak form of market efficiency	✓
Semi-strong form of market efficiency	✓	✓
Strong form of market efficiency	✓	✓	✓

Weak-Form Efficiency

• what information does it use?

• what does this imply?

• Prices reflect all past market data.

• Includes historical prices and trading volume.

• Past price patterns cannot predict future returns.

• Technical analysis should not consistently work.

  • Based on price and volume history.

  • Assumes investor behavior repeats in patterns.
    

Semi-strong-Form Efficiency

• what information does it use?

• what does this imply?

• Prices reflect all publicly available information.

  • Includes financial statements, news, and market data.

• Encompasses weak-form efficiency.

• Fundamental analysis cannot consistently produce abnormal returns.

  • All public information is already priced in.

  • Prices adjust quickly to new information releases.

Strong-Form Efficiency

• what information does it use?

• what does this imply?

• Prices reflect all information, both public and private.

• Even insiders cannot earn abnormal returns.

  • All private information is already in the price.

• Strong-form efficiency is not realistic in practice.

  • Insider trading evidence shows private information can be profitable.

  • Most markets fail strong-form efficiency tests.

What is fundamental analysis?

The analysis of public and private (estimate-based) information to estimate an asset’s intrinsic value.

summary of ability to make profit using the methods given for weak, semi strong, and strong form

• Weak form → technical analysis fails

• Semi-strong form → fundamental analysis rarely beats market unless superior

• Strong form → even insiders cannot outperform (not realistic)

What is an event study?

• Test how prices react to new public information.

1. Estimate expected return using a model (CAPM or market model).

2. Compare actual return vs expected return.

3. Calculate excess (abnormal) returns.

4. Test whether abnormal returns are statistically significant.

What is a market anomaly?

A return pattern that cannot be explained by new or relevant information, suggesting a possible market inefficiency.

What is data mining (data snooping), why is it dangerous, and what would be needed for a true anomaly?

• Many “anomalies” come from data snooping.

• Researchers test many patterns until one appears significant.

• This can produce false discoveries by chance.

• True anomalies are persistent over long periods and not just a result of a specific sample period.

time series anomalies

1. January Effect

• Returns are unusually high in January.

• Often strongest in small-cap stocks.

• Possible cause: tax-loss selling in December.

• Also explained by “window dressing” by fund managers.

• Evidence suggests it is not persistent after risk adjustment.

Other Calendar Patterns

1. Day-of-week effect: Mondays tend to be lower returns.

2. Weekend effect: weekend returns tend to be weaker.

3. Holiday effect: pre-holiday returns tend to be higher.

4. Turn-of-month effect: strength at month-end and start.

• Most calendar anomalies weaken or disappear over time.

• Often attributed to arbitrage or better statistical testing.

what is the overreaction effect

• Investors overreact to news.

• Prices become too high for winners and too low for losers.

• Reversal occurs over time.

• “Loser” stocks outperform “winner” stocks later.

what is the momentum effect?

• Short-term trends persist in returns.

• Recent winners continue to outperform briefly.

• This contradicts weak-form efficiency

what is the size effect?

• Small-cap stocks outperform large-cap stocks on average.

• Evidence was strong initially but weakened over time.

• Could be risk-related or a historical statistical artifact.

what is the value effect?

• Value stocks have low P/E and low price-to-book ratios.

• Growth stocks have high valuation ratios.

• Value stocks tend to outperform over long periods.

  • This challenges semi-strong efficiency.

• May reflect higher risk in value stocks.

• Or mispricing due to investor behavior.

1. Closed-end investment funds.

• shares trade at discount to net asset value (NAV)

• anomaly: value of the pool of assets should be the same as the market price

• transactions costs would eliminate any profits

2. Earnings announcements.

• earnings surprise: portion of announced earnings that was not expected by the market

• anomaly: adjustment process does not occur entirely on the announcement day.

• exploited by buying positive earnings surprise firms and selling negative earnings surprise firms.

• result of estimating risk-adjusted returns incorrectly in the tests

• transactions costs would eliminate any abnormal profits

3. Initial public offerings.

• IPOs are typically underpriced,

• However, the long-term performance of IPO shares as a group is below average.

• This suggests that investors overreact,

  • too optimistic about a firm's prospects on the offer day.

what is loss aversion, its market impact and its limitations?

• Losses feel worse than equivalent gains feel good.

• Investors strongly prefer avoiding losses.

market impact:

• Can lead to exaggerated reactions to negative news.

• Helps explain overreaction in some markets.

Limitation

• Markets also show underreaction.

• Loss aversion alone cannot explain all patterns.

what is herding behaviour and its market impact ?

• Investors follow others instead of their own information.

• Trading becomes clustered on the same side of the market.

• Herding may or may not be based on information.

Market Impact

• Can amplify price movements.

• May cause both overreaction and underreaction.

• It can distort price discovery.

what is Overconfidence and its market impacts?

• Investors overestimate their ability to interpret information.

Market Impact

• Leads to incorrect or delayed price adjustment.

• Can create temporary mispricing.

What is an information cascade and how does it impact the market?

When investors base decisions on observing others rather than their own information.

• more likely when information quality is low.

Market Impact

• Can create serial correlation in returns.

• May contribute to overreaction or mispricing.

what are four other behavioural biases?

1. Representativeness

• Investors rely on stereotypes or recent patterns.

• They overgeneralise from limited information.

2. Mental Accounting

• Investors treat money in separate “accounts.”

• Decisions depend on framing of each account.

3. Conservatism

• Investors update beliefs too slowly.

• stick to prior opinions despite new data.

4. Narrow Framing

• Investors evaluate decisions in isolation

• ignore broader portfolio context.