Professional Documents
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The concepts
Topics
What if you figure a stock price moving
pattern?
Some formal definitions
Implications of Market efficiency
Hypothesis
Price modeling
Empirical studies
What if?
Definitions
Implications
Price
Empirics
What if
What if you have figured the following:
Buy if out of the 20 trading days for the past
month, stock XYZ has been rising for more
than 2/3 of the times.
Sell if out of the 20 trading days for the past
month, stock XYZ has been falling for more
than 2/3 of the times.
Follow this rule strictly, return is abnormally
high.
What if?
Definitions
Implications
Price
Empirics
Definitions
Implications
Price
Empirics
Stock Price
Sell
Sell
Buy
Buy
Time
What if?
Definitions
Implications
Price
Empirics
The army
Imagine not only you, there exists an army of intelligent,
well-informed security analysts, arbitragers, traders, who
literally spend their lives hunting for securities which are
mispriced or following a price moving pattern based on
currently available information.
They have high-tech computers, subscription to professional
database, up-to-date information on thousands of firms, stateof-the-art analytical technique, etc.
These people can assess, assimilate and act on information,
very quickly.
In their intense search for mispriced securities, professional
investors may police the market so efficiently that they drive
the prices of all assets to fully reflect all available information.
What if?
Definitions
Implications
Price
Empirics
Implications
Competition for finding mispriced securities is fierce.
Such competition always kills the sure-profit pattern
because were there one, it would have been exploited by
someone who first spotted it. Thus, roughly speaking, no
arbitrage should hold.
The first one does make profit, but
net profit gross profit
The very first one is not likely to be you.
The implications:
stock prices should have reflected all available
information.
stock prices should be unpredictable.
What if?
Definitions
Implications
Price
Empirics
Unpredictability
Prices are unpredictable in the sense that
stock prices should have reflected all
available information.
Thus if stock prices change, it should be
reacting only to new information.
The fact that information is new means
stock prices are unpredictable.
What if?
Definitions
Implications
Price
Empirics
Market efficiency
If all past information is incorporated in the price
then it should be impossible to consistently beat
the market using technical analysis and the like.
Definition 1:
Eugene Fama defined Market Efficiency as the state
where "security prices reflect all available
information.
Definition 2:
Financial markets are efficient if current asset prices
fully reflect all currently available relevant information.
What if?
Definitions
Implications
Price
Empirics
Definitions
Implications
Price
Empirics
Information
in past stock
prices
What if?
Definitions
Implications
Price
Empirics
[1] Strong-form
Information
in past stock
prices
What if?
Definitions
Implications
Price
Empirics
Definitions
Implications
Price
Empirics
What if?
Definitions
Implications
Price
Empirics
What if?
Definitions
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What if?
Definitions
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As an analyst
As an investment manager
As a corporate financial manager
As a marketing manager
As an accounting manager
What if?
Definitions
Implications
Price
Empirics
Definitions
Implications
Price
Empirics
Definitions
Implications
Price
Empirics
Definitions
Implications
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Empirics
What if?
Definitions
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Definitions
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Expected return-risk
The market efficiency hypothesis says nothing about the
structure of stock prices. However, what is abnormal return?
Abnormal return = actual return expected return
This means we have to know what exactly is expected return.
Thats why we may use a pricing model.
e.g.,CAPM, to find a risk-adjusted return that the market will be
rewarding.)
Defining abnormal return inherently involves assuming a pricing
model. If we find abnormal returns, we conclude that the market
is inefficient. But then, we can also say that the pricing model
we used is invalid.
The challenge here is: testing market efficiency inevitably
involves testing a joint hypothesis:
H0 : both market is efficient and the pricing model is valid.
H1: EITHER market is inefficient OR the pricing model is
invalid.
What if?
Definitions
Implications
Price
Empirics
What if?
Definitions
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Empirics
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+t
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-t
+t
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Definitions
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What if?
Definitions
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Empirics
If capital markets are efficient, should we just throw darts at the Wall
Street Journal instead of trying to rationally choose a stock portfolio?
What if?
Definitions
Implications
Price
Empirics
What if?
The more efficient capital market is, the better off the society.
Definitions
Implications
Price
Empirics