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EFFICIENT MARKETS
The Efficient Market Hypothesis Most tests of EMH:
How fast information is incorporated in prices Not whether information is correctly incorporated
in prices Weak Form Semi-strong Form Strong Form
Fair Game
Information set Φt can not be used to earn excess return.
What is Φt? Weak form: past history of stock prices, company
characteristics, market characteristics, and the time of the year.
Semi-strong form: announcement of one or more pieces of information.
Strong form: all information
The Random Walk
Visualize a roulette wheel. Returns are IID over time. Fair game does not require returns to be IID
over time. Random walk is a restricted version of the fair
game.
Test Of Return Predictability
Time Patterns in Security Returns Returns are systematically higher or lower
depending on the time of the day, the day of the week, and the month of the year.
Intraday and Day-of-the-Week Patterns: Day-end effect. Week-end effect.
Monthly Patterns: Returns in January are substantially higher than return in
other months (January effect). Especially true for small stocks
January and Size Effect
Explanations of January Effect Microstructure explanation
(Keim, 1989): Last trade in December was
primarily at the bid, and this tendency was more pronounced for small stocks.
First trade in January was between bid and ask.
Return to appear high in the first few days of January.
Tax-selling hypothesis: Selling securities with
substantial losses before the year end.
This creates a tax loss which should cover more than transaction costs.
Purchasing similar securities in early January.
Test Of Return Predictability
Predicting Return from Past Return Short-term Predictability Correlation Tests Runs Tests Filter Rules Relative Strength Very Short-term Correlation Correlation for Portfolios of Securities
Test Of Return Predictability
Correlation over Long-run Horizons Returns and Firm Characteristics
The Size Effect Market to Book Earnings Price
Predicting Long-run Returns from Firm and Market Characteristics
Correlation Tests
A regression of the following model:
Correlation Tests
Weekly Correlation Coefficients
SAHAMLag 1
(p-value)
Telekomunikasi Indonesia (TLKM)
-0,04077
(0,759393)
Gajah Tunggal (GJTL)-0,03819
(0,774214)
Gudang Garam (GGRM)-0,03858
(0,770274)
Runs Tests
A price increase “+” A price decrease “-” No change “0” A sequence of the same sign is a “run”. + - - - +++ 0 4 runs Correlation and runs tests seem to show small
positive relationship between today’s and yesterday’s return, but on average it is very small, and frequently negative for individual securities.
Runs Tests
Announcement and Price Return The greatest amount of research in finance
has been devoted to the effect of an announcement on share price.
“Event Study” how fast the information was incorporated in share price.
Dozens of studies confirm that share price reacted rapidly to announcements, and in expected direction of the price change.
Methodology of Event Studies Collect a sample of firms that had a surprise
announcement (the event) Determine the precise day of the
announcement and designate this day as “zero”
Define the period to be studied For each of the firms in the sample, compute
the return on each of the days being studied.
Methodology of Event Studies Compute the “abnormal” return for each of
the days being studied for each firm in the sample
Compute for each day in the even period the average abnormal return for all the firms in the sample.
Often the individual day’s abnormal return is added together to compute the cumulative abnormal return from the beginning of the period.
Examine and discuss the results
Methodology of Event Studies
Methodology of Event Studies
Results of Some Event Studies Market efficiency with respect to purchase or
sale of securities announcement. Whether analysts’ information could be used
to earn excess returns of if it was already incorporated in share price.
Dividend and stock split announcement.
Results of Some Event Studies
Results of Some Event Studies
Strong Form Efficiency
Insider Trading Information in Analysts’ Forecasts Mutual Fund Performance
Market Rationality
Volatility Tests Winners-Losers Market Crash of October 1987