An efficient market adjusts extremely quickly to new information (egg. Profit reports). The stock market fully adjusts to profit reports so quickly after their release that an investor cannot make extra returns from the profit information. Theory of Efficient Markets The rationale behind market efficiency is the existence of many analysts in the market who could profit from any slow market adjustment (by arbitrage). If the market took a considerable time to adjust to a piece of information, then an opportunity would exist to buy or sell before the market adjustment was completed.
If analysts decided to take advantage of those opportunities, then their efforts to buy or sell would force prices up or down immediately. This would remove the slow market adjustment. The adjustment would occur as soon as the analysts perceived it to be slow. Thus, market efficiency is a result of competition among investors. There are several misconceptions of the efficient market hypothesis. Some are addressed below: 1. It does not claim that every scrap of information is fully reflected in prices. Obviously “inside” information is not necessarily known to the market and therefore this type of information is not reflected in price. . It does not mean that the market makes no mistakes, but it is one in which share prices are unbiased. It is unreasonable to claim that the share market made a stake because, in hindsight, prices have fallen or risen. This involves using information which was not available at the time. In an efficient market, share prices information, shares are neither under nor overvalued, but are on average correctly valued. Of course, subsequent information will become available and prices will change. 3. It does not mean that the share market is irrational.
Quite the opposite. In the early days, the concept was known as the “random walk hypothesis”, named after the statistical process that prices on average follow in an efficient market. The probability of a price increase is the same as the probability of a price decrease (e. 50%). The name random walk is misleading as the word random suggests lack of order whereas the rationale behind the efficient market is the market analyses information that is available and behave quite. Information enters the market in a random fashion.
Market Efficiency Classification of Degrees of Efficiency When discussing market efficiency, the question is not whether the market is efficient or not, but what is the extent of its efficiency. That is, how efficient/inefficient is it? Having described an efficient market as one which adjusts quickly and in an unbiased manner to new information, the classifications of efficiency are in accordance with different types of information. Weak-Form Efficiency – implies that the information contained in the past/historical sequence of prices of a security is fully reflected in the current market price of that security.
A chartist examines and plots the past sequence of stock prices to identify “familiar” trends. If the price of a security is falling over time, a chartist would suggest that the price will continue to fall as established by the trend. However, if the market is weak form efficient, this trend cannot be used to predict – any information from the trend is already reflected in the price. Given today’s price, tomorrow’s price may fall (50% probability) or rise (50% probability). This is the random walk pattern.
Semi-Strong Form Efficiency – all publicly available relevant information is fully reflected in share price virtually instantaneously upon its release. While many investors agree that the past sequence of prices cannot be used to predict the future sequence of prices (e. Agree that the market is weak-form efficient), some investors are less prepared to accept that these inferences extend to publicly available information (annual reports, profit announcements, etc). If the market is semi-strong form efficient, then prices should adjust so quickly that it is impossible to make abnormal gains from trading on the newly released information.
That is, if I pick up the morning paper and read that Bank of Queensland to cash-in on the good news. The price has already adjusted. Share prices reflect expectations. Expectations are formed on available information. Information or news is generated in a random fashion. The various competing news services rush this news to the presses. The news is not delayed or controlled in any systematic manner; it is widely dispersed and available to the public at virtually no cost. There are no significant learning lags associated with news dissemination.
The reaction to news is immediate and continuous until the news is fully impacted into security prices. Strong-Form Efficiency – is where all information (including both publicly available and private “inside” information) is fully reflected in security prices. This is the highest form of efficiency and suggests that prices react to information which is know privately within the firm, but has not yet been made public. General Discussion While some people find it easy to accept that information that is pertinent to the performance of a company, but is not yet public information (e. Inside information) can lead to profitable trading, they do not find it easy to accept that this rarely extends to public information. Further, Judging from the number of charting services, it is apparent that many people believe that profitable rules even extend to examining historical prices. The market is extremely competitive. There exists no barriers to entry with respect to publicly available information and therefore normal profits only should be earned. The marginal cost of obtaining public information is zero; therefore the marginal benefit of using public information is zero.
If we examine any system (charting, technical indicators, fundamental analysis) through time, we will discover that the followers of the system will earn normal returns for the level of risk they bore. The system is really selling a “peace of mind” and not a “piece of the action”. Empirical Evidence The evidence falls into three groups: 1 . Weak-form efficiency tests which are concerned with historical price sequences; ND 3. Strong-form efficiency tests concerned with inside or monopolistic information. Weak Form Tests Weak form tests of market efficiency are the most numerous.
Researchers test for evidence of dependence in day to day price changes to see if the dependence is of a form that can be used as the basis of marginally profitable trading. When brokerage and transactions costs are taken into account, costs outweigh benefits. Studies by Fame, Blame and Alexander are the most notable and the general conclusion is that changes in price sequences are not significantly different from the changes in sequences in a table of random numbers. Semi Strong Form Tests What is tested is that prices are assumed to fully reflect all publicly available information.
Studies by Fame, Fisher, Jensen & Roll, Ball & Brown and Schools are the most notable. It has been found that the informational content of stock splits, block sales, new issues and earning announcements are on average fully reflected in the security prices at the time of the announcement and in fact the market anticipates up to 85% of the information. As a result, it may be concluded that security prices reflect publicly available relevant information as suggested by the semi strong form hypothesis. Strong form Tests A strong form efficient market is where all information (not Just publicly available) is fully reflected in security prices.
All that needs to be done is to find one insider who has profited (abnormally) from inside information and the hypothesis that the market is strong form efficient is not supported. This is the most difficult form of market efficiency to test, because it is difficult to isolate exactly who has private information and when they are trading on it. In the United States various studies and actions taken by the Securities Exchange Commission suggest that some corporate insiders are able to profit from monopolistic access to information. The market is therefore not strong form efficient.
In summary, the market is (at least) semi strong form efficient where information is virtually instantaneously reflected in share price. The basic premise underlying the risk / return relationship is that the stock market is an efficient mechanism in pricing the securities of business organizations. So that we find that the theory behind the CAMP and the MME drive much of the research conducted in the field of finance. Many tests have been conducted into market efficiency. Often these test support market efficiency and the CAMP and occasionally they turn up results which do not appear to be consistent with the theory.
These regularities or pattern are often referred to as “anomalies”. A very famous anomaly is the January Effect. For some reason not fully understood returns in January are higher than predicted by theory (even after adjustment for risk). On average shareholders make higher returns in January than any other month. This phenomenon has persisted over several decades since it was discovered. Possible explanations include: 1. The market is inefficient . Poor or inadequate research 3. CAMP does not capture all risk and return The Jury is out. Your text covers a range of these anomalies.
They are examinable as are the various research methodologies covered in Chapter 16. Topic 10. 3: Capitalization Changes [B] Dividend Drop-off This discussed in Chapter Eleven of your textbook, in particular on page 336. When a firm pays a dividend it effectively reduces its equity by the amount of the dividend. An explanation of the time line in the dividend process might help to explain this idea. The process of declaring a dividend involves four significant dates. They are: viewed as good or bad news – this is referred to as the information content).
D Ex- Dividend date (if you buy a share on or after this date you buy it without the dividend – the seller retains the right to receive the dividend when it is paid). If you buy the share before this date you are buying “UCM” dividend (with dividend). E Books close date (five working days after the ex-dividend date – this give time for the people who are keeping a record of owners to record all registered owners – registered owners receive the dividend). B Payment date (cheeses mailed to registered winners). P If you buy the share on ex-dividend date would you be prepared to pay same price as the day before?
Remember if you buy the day before you receive the dividend, but if you buy on ex-dividend day you do not receive the dividend. Assuming that nothing else has happened in the market the answer is no, because you miss out on the cash from the dividend. So on ex-dividend date the price of the share should adjust downwards by the amount of the dividend. This is sometimes called Dividend Drop- off. The proportion of the drop in price relative to the amount of the dividend is referred o as the drop-off ratio. Example Pylorus’s shares are selling for $12. 0. Polymorph declares a dividend of $1. 75 per share. Assuming that the price is $12. 50 before the shares go ex-dividend, what would the ex-dividend price be in an efficient market? Solution Ex-dividend price should be 12. 50 -1. 75= 10. 75 Stock Splits Stock Splits (or share splits) are covered in Section 9. 9. A stock split occurs when a firm to split its shares, so that the number of share on offer is increased. The traditional explanation for doing this is to bring the price of its shares down to a value which is more marketable.
For example in a two for one stock split a company issues two new shares in place of each existing share. So if you owned 20 shares worth $10 each, you would end up with 40 shares in their place. No money changes hand between the company and the shareholders. The shareholder company are unchanged. The only thing that occurs is a book entry and some paper exchanges hands. Question In an efficient market, what will be the share price on ex-split date? Assume the price before the share goes “EX” is $10. You started with 20 shares each worth $10; a total of $200. After the split you have 40 shares.
Given that nothing fundamental has occurred to the company your total ownership should be $200, but now this is spread over 40 shares. The new price should be $5. 00, if the market is efficient. Bonus Share Issues These are also covered on Section 9. 9 of the text. A bonus share or bonus issue is the issue of free shares to existing shareholders in proportion to their holdings. For example, in a one for one bonus issue the shareholder receives one new share for free for every share she/he owns. The economics of splits and bonus issues is similar; the difference is in the paperwork and accounting.
No money changes hands, earnings are unchanged and the assets of the firm are unchanged, so in an efficient market the share price should adjust for the free component. “There are no free lunches”! Assume a price of $20 and a company makes a bonus issue of one for one. In an efficient market, what will be the share price on ex-bonus date? Assume the price You started with shares each worth $20. After the issue you have 2 shares for everyone you started with. Given that nothing fundamental has occurred to the company the new share price should be $10 ($20/2). Rights Issue
A rights issue is an issue of new share to existing shareholders in proportion to their holdings and a price less than the current market price of the shares. The shareholders have the right but not necessarily the obligation to buy new share at less than market price.
