Efficient Market hypothesis (EMH)
When security prices fully and fairly reflect all available information
What does EMH imply about stock prices and fundamental value?
Stock prices equals the present value of discounted future dividends
What is Behavioural finance?
The study of how reasoning errors and psychology affect investor decisions and market prices.
What is arbitrage?
Simultaneous buying and selling to exploit misplacing and earn profits
What is a noise trader?
An investor whose trades are not based on information or fundamental analysis
Weak form efficiency means
Prices reflect all past price and volume information
Semi strong form efficiency means
Prices reflect all publicly available information
Strong form efficiency means
Prices reflect all public and private information
If markets are weak form efficient, what analysis is useless?
Technical
If markets are semi strong efficient, what analysis is useless?
Fundamental analysis
How does EMH treat irrational investors?
Their errors are independent and cancel out
Three possible price reactions to new information
Efficient reaction, delayed reaction, overreaction & correction
What is overreaction?
Prices over adjust to new information and later correct
What are limits to arbitrage?
Real world constraints that prevent arbitrageurs from correcting mispricing
Fundamental risk
Risk that bad news worsens mispricing and causes losses
Noise trader risk
Risk that irrational traders become more irrational before prices correct
Two implementation costs of arbitrage
Trading costs
Short sale constraints
Financial bubble
Prices rise far above levels justified by fundamentals
What did Shiller (1981) show?
Stock prices are more volatile than dividends justify
January effect
Small firms earn higher returns in January
Small firm effect
Small firms earn higher risk adjusted returns than large firms
momentum
Stocks that perform well continue to perform well in the short term
What happens when firms add dot com to their name?
large positive abnormal returns even without fundamentals
