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Add to cart(ii) A researcher has analysed the annual returns of equity stocks in a particular
country over a 10-year period and has made the following observations:
(a) Annual market returns in consecutive years have a negative correlation of
–0.25.
(b) The closing value of the index of the 100 stocks with the highest market
capitalisation has been found to be 1% higher on average on Fridays than
on Mondays.
(c) Announcements of changes in company’s dividend policies typically take
three months to become fully reflected in the quoted share price.
(d) The prices of a particular subset of stocks have been consistently
observed to fall immediately following a favourable announcement and
to rise immediately following an unfavourable announcement.
Discuss these observations in the light of the EMH. [4]
[Total 6]
(ii)
Discuss the observations
(a)
Annual market returns are negatively correlated
This observation suggests that, over annual time periods, the market tends to
systematically overreact to new information and hence that the market may not be semistrong form efficient.
In addition, trading rules could be developed based on this information that could
generate excess, risk-adjusted returns, which suggests that this observation is
inconsistent with the weak form of the EMH.
(b) The index is higher on Fridays than on Mondays
The observation suggests that there is a consistent tendency for prices on Fridays to be
“inflated”, while prices on Mondays are “depressed”, ie there is a systematic bias
present in the prices.
Trading rules could be developed based on this information (eg buy on Monday, sell on
Friday) that could generate excess, risk-adjusted returns, which suggests that this
observation is inconsistent with the weak form of the EMH.
(c) Announcements take three months to be reflected
If the semi-strong form of the EMH holds, public dividend announcements should have
an immediate effect on the share prices as the market should respond quickly and
accurately to new information.
This observation suggests that the market is not semi-strong form efficient.
(d) Prices fall following a favourable announcement
The prices are reacting when information is made public. This suggests that the prices
have previously been distorted by insider information.
Therefore, this observation contradicts the strong form of the EMH.
Note that, once a particular form of the EMH is contradicted, this also contradicts any
of the stronger forms.
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Discuss the following statement:
The existence of fund managers who sell their services based on their alleged ability to
select over-performing sectors and stocks and so add value to portfolios demonstrates
that capital markets are not efficien
The Efficient Markets Hypothesis (EMH) suggests that it is not possible to achieve
excess risk-adjusted investment returns using investment strategies based only on
certain subsets of information. The existence of fund managers who sell their services
based on their alleged ability to select over-performing sectors and stocks does not
demonstrate that capital markets are inefficient.
In particular, the semi-strong form of the EMH suggests that excess risk-adjusted
investment returns cannot be obtained using only publicly available information.
In certain investment markets, it may therefore be possible (and legal) to achieve excess
returns using privileged or inside information, which fact would not contradict the semistrong form of the EMH.
More generally, the EMH does not preclude managers achieving higher investment
returns by adopting “riskier” investment strategies and receiving due reward for the
risks taken. It says precisely that it is not possible to develop investment strategies that
yield excess risk-adjusted returns – though it is difficult to determine exactly how risk
should be interpreted in this context.
Some fund managers must necessarily achieve higher than average returns over a given
short time period – eg several years. The point of the EMH is that managers cannot
consistently achieve above excess returns. Moreover, they cannot guarantee to achieve
excess returns over any particular time period.
Finally, rather than reflecting any market inefficiency in contradiction of the EMH, the
existence of such managers may instead reflect the following facts:
● individual investors may be unaware of the EMH or choose not believe it and
hence may be inclined to believe the claims of such managers and so place
money with them.
● certain individual investors may choose to believe the claims of such managers,
reflecting the fact that investment decisions are often made on the basis of
subjective and emotional factors, in addition to, or instead of on the basis of
financial theory.
For the above reasons, the existence of such fund managers does not therefore
demonstrate that capital markets are inefficient.
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What is the relationship between the three forms of market efficiency?
Publicly available information is a subset of all information, whether publicly available
or not. Consequently strong form efficiency implies semi-strong form efficiency, in the
sense that if a market is strong form efficient, then it must also be semi-strong form
efficient.
Similarly as historical price data is a subset of all publicly available information, so a
market that is semi-strong form efficient must also be weak form efficient.
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Why would such rules be unnecessary?
Such rules would be unnecessary because it would not be possible for senior
management to use this information to obtain higher investment returns by trading in
the stock of their own company. Thus, senior management would not be at an
advantage compared to other investors, who would correspondingly not be
disadvantaged by such trades.
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Why can active management not be justified according to the EMH?
According to the Efficient Markets Hypothesis, active investment management cannot
be justified because it is impossible to exploit the mispricing of securities in order to
generate higher expected returns. Even if price anomalies exist, then the costs of
identifying them and then trading will outweigh the benefits arising from the additional
investment returns.
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Comment on the advantages that could be derived from “insider trading” in a market
that is strong form efficient.
If the market is strong form efficient, then there will be no advantage from insider
trading because all the insider knowledge should be reflected in the current share price.
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Country X runs a national lottery in which the purchaser of a ticket selects six different
numbers from 1 to 50 inclusive. If those same six numbers are then drawn randomly
from a hat on live TV, the holder of the ticket wins a share of a large cash sum equal in
value to the total ticket sales.
Is the market for lottery tickets weak form efficient?
If the numbers drawn are truly random, then the market for lottery tickets is weak form
efficient, as knowledge of the numbers that have been drawn in the past will not help
you to predict the numbers that are likely to be drawn in the future, and thereby generate
excess returns. It will also be semi-strong and strong form efficient, unless it is
operated fraudulently
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Over the last five years, the shares of Company A have yielded an average investment
return twice that of Company B. Does this contradict the Efficient Markets Hypothesis?
Although Company A’s shares have recently yielded more than Company B’s shares,
this does not contradict the Efficient Markets Hypothesis (EMH). This is because the
EMH implies that it is not possible to identify shares that offer excess risk-adjusted
expected returns. This is different from the situation described, which refers to actual
past returns with no allowance being made for the relative riskiness of the two shares
involved. Thus Company A may be inherently more risky than Company B. Even if it
isn’t, then it may not have been possible to predict Company A’s success in advance.
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Create quizA researcher has analysed the annual returns of equity stocks in a particular
country over a 10-year period and has made the following observations:
16 questions
English
02-07-2024
University / Open University / Accounting and Finance / Economics and Actuarial Science