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ERIC WANG
Chapter8solution.pptx
8. The Efficient Market Hypothesis
Instructor: Seongcheol Paeng
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
Explain Competition as the Source of Efficiency.
This point has been stressed by Grossman and Stiglitz (1980). They argued that investors will have an incentive to spend time and resources to analyze and uncover new information only if such activity is likely to generate higher investment returns.
Example 8.1 Consider an investment management fund currently managing a $5 billion portfolio. Suppose that the fund manager can devise a research program that could increase the portfolio rate of return by one-tenth of 1% per year, a seemingly modest amount. This program would increase the dollar return to the portfolio by $5 billion × .001, or $5 million.
Therefore, the fund would be willing to spend up to $5 million per year on research to increase stock returns by a mere tenth of 1% per year. With such large rewards for such small increases in investment performance, it should not be surprising that professional portfolio managers are willing to spend large sums on industry analysts, computer support, and research effort, and therefore that price changes are, generally speaking, difficult to predict.
With so many well-backed analysts willing to spend considerable resources on research, easy pickings in the market will be rare. Moreover, the incremental rates of return on research activity may be so small that only managers of the largest portfolios will find them worth pursuing.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
2. Explain Versions of the Efficient Market Hypothesis.
It is common to distinguish among three versions of the EMH: the weak, semi-strong, and strong forms of the hypothesis.
The weak-form hypothesis asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest.
The semi-strong-form hypothesis states that all publicly available information regarding the prospects of a firm already must be reflected in the stock price.
Finally, the strong-form version of the efficient market hypothesis states that stock prices reflect all information relevant to the firm, even including information available only to company insiders.
7/25/2020
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Problem Sets (Paraphrase with your own words.)
Explain the Weak-Form with examples.
While broad market indexes demonstrate only weak serial correlation, there appears to be stronger momentum in performance across market sectors exhibiting the best and worst recent returns.
Momentum Effect: The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
In an investigation of intermediate-horizon stock price behavior (using 3- to 12-month holding periods), Jegadeesh and Titman (1993) found a momentum effect in which good or bad recent performance of particular stocks continues over time.
They conclude that while the performance of individual stocks is highly unpredictable, portfolios of the best-performing stocks in the recent past appear to outperform other stocks with enough reliability to offer profit opportunities.
Although short- to intermediate-horizon returns suggest momentum in stock market prices, studies of long-horizon returns (i.e., returns over multiyear periods) by Fama and French (1988) and Poterba and Summers (1988) indicate pronounced negative long-term serial correlation in the performance of the aggregate market.
The latter result has given rise to a “fads hypothesis,” which asserts that the stock market might overreact to relevant news. Such overreaction leads to positive serial correlation (momentum) over short time horizons. Subsequent correction of the overreaction leads to poor performance following good performance and vice versa.
The corrections mean that a run of positive returns eventually will tend to be followed by negative returns, leading to negative serial correlation over longer horizons. These episodes of apparent overshooting followed by correction give the stock market the appearance of fluctuating around its fair value.
Reversal effect: The tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
4. Explain the Semi-Strong Form with examples.
Market Anomalies
Fundamental analysis uses a much wider range of information to create portfolios than does technical analysis. Investigations of the efficacy of fundamental analysis ask whether publicly available information beyond the trading history of a security can be used to improve investment performance, and therefore they are tests of semi-strong-form market efficiency.
Surprisingly, several easily accessible statistics, for example a stock’s price–earnings ratio or its market capitalization, seem to predict abnormal risk-adjusted returns. Findings such as these, which we will review in the following pages, are difficult to reconcile with the efficient market hypothesis and therefore are often referred to as efficient market anomalies.
anomalies: Patterns of returns that seem to contradict the efficient market hypothesis.
An example of this issue is the discovery by Basu (1977, 1983) that portfolios of low price–earnings (P/E) ratio stocks have higher returns than do high P/E portfolios.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
4. Explain the Semi-Strong Form with examples.
The Small-Firm Effect
The so-called size or small-firm effect, originally documented by Banz (1981), is illustrated in Figure 8.3.
It shows the historical performance of portfolios formed by dividing the NYSE stocks into 10 portfolios each year according to firm size (i.e., the total value of outstanding equity).
Average annual returns between 1926 and 2013 are consistently higher on the small-firm portfolios.
The Neglected-Firm And Liquidity Effects
Merton (1987) provides a rationale for the neglected firm effect. He shows that neglected firms might be expected to earn higher equilibrium returns as compensation for the risk associated with limited information. In this sense the neglected-firm premium is not strictly a market inefficiency but is a type of risk premium.
Work by Amihud and Mendelson (1986, 1991) on the effect of liquidity on stock returns might be related to both the small-firm and neglected-firm effects. They argue that investors will demand a rate-of-return premium to invest in less liquid stocks that entail higher trading costs.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
4. Explain the Semi-Strong Form with examples.
Book-To-Market Ratio
Fama and French (1992) showed that a powerful predictor of returns across securities is the ratio of the book value of the firm’s equity to the market value of equity.
Fama and French stratified firms into 10 groups according to book-to-market ratios and examined the average rate of return of each of the 10 groups.
Figure 8.4 is an updated version of their results. The decile with the highest book-to-market ratio had an average annual return of 17.5%, while the lowest-ratio decile averaged only 11.0%.
In fact, Fama and French found that after controlling for the size and book-to-market effects, beta seemed to have no power to explain average security returns.
This finding is an important challenge to the notion of rational markets because it seems to imply that a factor that should affect returns—systematic risk—seems not to matter, while a factor that should not matter—the book-to-market ratio—seems capable of predicting future returns.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
4. Explain the Semi-Strong Form with examples.
Post-Earnings-Announcement Price Drift
Rendleman, Jones, and Latané (1982) provide an influential study of sluggish price response to earnings announcements.
They calculate earnings surprises for a large sample of firms, rank the magnitude of the surprise, divide firms into 10 deciles based on the size of the surprise, and calculate abnormal returns for each decile.
The abnormal return of each portfolio is the return adjusting for both the market return in that period and the portfolio beta.
Figure 8.5 plots cumulative abnormal returns by decile. Their results are dramatic. The correlation between ranking by earnings surprise and abnormal returns across deciles is as predicted.
There is a large abnormal return (a jump in cumulative abnormal return) on the earnings announcement day (time 0). The abnormal return is positive for positive-surprise firms and negative for negative-surprise firms.
The more remarkable, and interesting, result of the study concerns stock price movement after the announcement date.
The cumulative abnormal returns of positive-surprise stocks continue to rise—in other words, exhibit momentum—even after the earnings information becomes public, while the negative-surprise firms continue to suffer negative abnormal returns.
The market appears to adjust to the earnings information only gradually, resulting in a sustained period of abnormal returns.
Evidently, one could have earned abnormal profits simply by waiting for earnings announcements and purchasing a stock portfolio of positive-earnings-surprise companies.
These are precisely the types of predictable continuing trends that ought to be impossible in an efficient market.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
4. Explain the Semi-Strong Form with examples.
Bubbles and Market Efficiency
It is hard to defend the position that security prices in these instances represented rational, unbiased assessments of intrinsic value.
And, in fact, some economists, most notably Hyman Minsky, have suggested that bubbles arise naturally.
During periods of stability and rising prices, investors extrapolate that stability into the future and become more willing to take on risk.
Risk premiums shrink, leading to further increases in asset prices, and expectations become even more optimistic in a self-fulfilling cycle.
But, in the end, pricing and risk taking become excessive and the bubble bursts.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
5. Explain the Strong Form with examples.
Inside Information
The study by Seyhun (1986), which carefully tracked the public release dates of the Official Summary, found that following insider transactions would be to no avail.
Although there is some tendency for stock prices to increase even after the Official Summary reports insider buying, the abnormal returns are not of sufficient magnitude to overcome transaction costs.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
6. Are market efficient? Explain with Mutual Fund Managers’ examples.
Figure 4.4 in that chapter demonstrated that between 1972 and 2013 the returns of a passive portfolio indexed to the Wilshire 5000 typically would have been better than those of the average equity fund.
On the other hand, there was some (admittedly inconsistent) evidence of persistence in performance, meaning that the better managers in one period tended to be better managers in following periods.
Such a pattern would suggest that the better managers can with some consistency outperform their competitors, and it would be inconsistent with the notion that market prices already reflect all relevant information.
Figure 8.7 shows a frequency distribution of four-factor alphas for U.S. domestic equity funds. The results show that the distribution of alpha is roughly bell-shaped, with a slightly negative mean. On average, it does not appear that these funds outperform their style-adjusted benchmarks.
Consistent with Figure 8.7, Fama and French (2010) use the four-factor model to assess the performance of equity mutual funds and show that while they may exhibit positive alphas before fees, after the fees charged to their customers, alphas were negative.
Likewise, Wermers (2000), who uses both style portfolios as well as the characteristics of the stocks held by mutual funds to control for performance, also finds positive gross alphas but negative net alphas after controlling for fees and risk.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
6. Are market efficient? Explain with Mutual Fund Managers’ examples.
Carhart (1997) reexamines the issue of consistency in mutual fund performance to see whether better performers in one period continue to outperform in later periods.
He uses the four-factor extension described above and finds that after controlling for these factors, there is only minor persistence in relative performance across managers.
Figure 8.8, from his study, documents performance persistence. Equity funds are ranked into 1 of 10 groups by performance in the formation year, and the performance of each group in the following years is plotted.
It is clear that except for the best-performing top-decile group and the worst-performing 10th-decile group, performance in future periods is almost independent of earlier-year returns.
Carhart’s results suggest that there may be a small group of exceptional managers who can with some consistency outperform a passive strategy, but that for the majority of managers over- or underperformance in any period is largely a matter of chance.
Bollen and Busse (2004) find more evidence of performance persistence, at least over short horizons.
They rank mutual fund performance using the four-factor model over a base quarter, assign funds into one of 10 deciles according to base-period alpha, and then look at performance in the following quarter.
Figure 8.9 illustrates their results. The solid line is the average alpha of funds within each of the deciles in the base period (expressed on a quarterly basis).
The steepness of that line reflects the considerable dispersion in performance in the ranking period.
7/25/2020
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Assignments
Problem Sets (Paraphrase with your own words.)
6. Are market efficient? Explain with Mutual Fund Managers’ examples.
The dashed line is the average performance of the funds in each decile in the following quarter.
The shallowness of this line indicates that most of the original performance differential disappears.
Nevertheless, the plot is still clearly downward-sloping, so it appears that at least over a short horizon such as one quarter, there is some performance consistency.
However, that persistence is probably too small a fraction of the original performance differential to justify performance chasing by mutual fund customers.
An overly doctrinaire belief in efficient markets can paralyze the investor and make it appear that no research effort can be justified. This extreme view is probably unwarranted. There are enough anomalies in the empirical evidence to justify the search for underpriced securities that clearly goes on.
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