Advanced Investment and Theory - Essay Example

Advanced Investment and Theory Contents Contents 2 Introduction 3 Literature Review 3 Discussion 6 Answer 6 Answer 2 8 Answer 3 9 Conclusion 10 References 11 Introduction The term efficiency is central to finance. It is used to describe a market where useful information can be found from the price of financial assets. Many economist use the word operational efficiency to emphasize the way resources are used to facilitate the operation of the market. According to microeconomics in case of competitive capital markets, the investors are not expected to have abnormal returns from their investment strategies. Though it is self-evident today, previously there were few empirical studies of securities market until 1950s. Market efficiency was brought into notice by Bachelier (1900) in his dissertation submitted for his PhD in mathematics. He identified that past, present and discounted future events can be found from market price but they show no significant relation with respect to price changes. According to him if the market cannot predict its fluctuations then it does assess them as being more or less likely and this likelihood can be found out mathematically. During the first half of the twentieth century there have been many emerging theories on speculative markets. But earlier literature did not sit easily with beliefs of practitioners. According to Bachelier the commodity prices vary randomly. Later Jones, Cowles (1937) and Working (1934) showed that the US stock prices also shared similar characteristics. But these studies did not surfaced out until the late 1950s. Many studies were done regarding the difficulty in beating the equity market. Cowles (1933) concluded that there was no evidence of any ability to outperform the market. He later provided evidence on large number of sample stock for longer time period and came out with similar results. Literature Review Kendall (1953) performed an experiment on 22 UK stock and commodity price series. He found that in a series of prices that were studied at fairly close intervals the random changes from one price to another was so large that it ruled out any systematic effect. Basically the data behaved like a wandering series. This observation was inconsistent with the views of economist and it came to be known as random walk theory or random walk model. This led to a major challenge for the market analyst who tried to predict future path of security prices. Osborne (1959) studied US stock prices and found that common stock prices have characteristics similar to movement of molecules. Despite such evidence of randomness there were few instances of anomalous behaviour, certain price series appeared to follow predictable paths. This comprised of a subset of commodity and stock price series (Raghunathan and Rajib, 2007, p. 213). Samuelson (1965) found that the random walk model was consistent with efficient markets hypothesis. He found that in competitive markets there would be buyers and sellers. If one of them is sure that price would raise then it would have risen. He asserted that arguments like this are used to deduce that price changes are displayed by competitive prices. According to Samuelson it is expected that people in the market place who are in pursuit of self-interest and avid, takes into account those elements of future events which are discerned to cast their shadows before them. Fama (1970) and Harry Roberts (1967) assembled a detailed review of the theory and evidence of market efficiency. This theory defines an efficient market as one in which with available information it impossible to generate superior profits. A market is said to be efficient only when we have a model for returns. Thus joint tests of models of asset pricing and market behaviour are two parts of tests of market efficiency (Kothari, 2001, pp. 121-130). Weak form of efficient market hypothesis indicates that all past stock prices are reflected in present stock price. Semi strong form of hypothesis accepts that all publicly available information is reflected in the stock price. Strong form of market efficiency states that all information in the market whether private or public is reflected in the stock price. Private information like insider information could not give investors the advantage of getting superior returns. Fama (1970) made several studies on historical sequence of prices and concluded that the results indicate that weak form of market efficiency persists. He further stated that there is extensive evidence in support of efficient markets model and contradictory evidence is sparse. At the same time he concedes that much remains to be done in this field. Many studies were conducted on semi-strong form of efficient markets hypothesis and the principal tool used in this area is the event study. The first event study was undertaken by Roll, Jensen, Fisher and Fama (1969). Using capital asset pricing model and market model as the benchmark, these studies provided evidence on the reaction of stock prices to earnings and stock splits announcements respectively. It was found that, the market anticipates the information and the price get adjusted even before the event is revealed to the market. When news comes out, the remaining adjustment happens accurately and rapidly. The study revealed that stock prices indicate that prices not only reflects prospective performance of the sample companies but also reflects the information which is subtle in nature. Scholes (1972) examined stock price movements when seller holds non-public information. Share price on average falls by an amount which reflects the value of the information. Size of transaction does not affect the impact of a secondary distribution on stock price. This indicates substitutability of one security for another (Sollis, 2012, p. 146). There have been numerous papers on demonstrating that new information will provide substantial gains. Insiders who have access to privileged information generated excess returns and thus violated the strong form of efficient market hypothesis. But Cowles (1933, 1944) made it clear that investment professionals cannot beat the market. Jensen (1968) cited an article on the performance of fund managers of 115 mutual funds over the period from 1955-64. He found that any advantage which portfolio managers might have is consumed by expenses and fees. He concluded that on an average the funds apparently were unsuccessful in their trading deeds to recover even the brokerage expenses. Fama (1991) did research on mutual fund and performance of institutional portfolio manager. He found that some mutual funds have achieved supernormal gross returns before expenses and have underperformed on the yardsticks on a risk-adjusted basis. It is important to understand that efficient market hypothesis considers small abnormal returns before expenses and fees. Thus there are incentives for analyst to act on the basis of valuable information inspite of the fact that investors cannot receive more than average bet return. Discussion Answer 1 It is not possible for investors to find trends in the stock prices and beat the market. Maurice Kendall in 1953 published a study in which he found that there was no discernible pattern in stock price movements. Irrespective of past price movement prices were as likely to go down as they were to go up on any given day. Thus it was clear that past performance did not influence stock prices else the investors would have earned abnormal profits easily. By simply building a model for calculation of probable next price movement would have enabled market participants to obtain large profits without or with risk. On the other hand, if everybody could have done the same thing, stocks that were about to rise would have risen instantly, since large numbers of market participants would have wanted to buy them while those holding the stock would not have wanted to sell. The concept of market efficiency incorporates the information into security prices. Thus any available information which influences stock performance of a company will already be reflected in the stock price of the company. In an efficient market, the security prices should be equal to the investment value of the security where investment value is the discounted value of the future cash flows of the security as estimated by capable and knowledgeable analyst. In weak form of efficient market hypothesis, stock prices reflect market trading data and information derived from it. These include past prices, short interest or volume. This data is easily available and hence according to this theory current prices should reflect all these. Thus this theory basically indicates that fundamental analysis is used to identify overvalued and undervalued stocks and technical analysis cannot be used to beat and predict the market. There are three types of test which are used to empirically verify the weak form efficient market hypothesis. These are serial correlation test and runs test. Serial Correlation test: Serial Correlation tests are one way to test for randomness in stock price changes. This test finds out if the price change in one period is correlated with price change in another period. In case such auto-correlations are negligible then it is concluded that price changes are serially independent. But these studies have failed to find any significant serial correlations. Runs Tests: For example given a series of price changes, each price change is designated as plus (+) in case it is an increase while a minus (-) represents a decrease. For example, a series may look like + + - + +- - + A run occurs when no difference between the sign of two changes and when the sign change differs the run ends and a new run begins. For example for the above series there are five runs To test if a series of price changes is independent, the number of runs in that series is compared with the number of runs in a purely random series of the same size and see of it is statistically any different. Answer 2 Under weak form of efficient market hypothesis, fundamental analysis might generates abnormal profits because the current asset prices might not reflect information of a particular company which an investor might have access to like information of earnings, growth rate, dividend etc. Second dividend discount model acts as a fundamental analysis. According to Gordon model, the value of a stock is The intrinsic value of a stock is known as fundamental value and analysing the intrinsic value of stock is similar to fundamental analysis. Individuals who believe in fundamental analysis believes that if a stock is undervalued, that is if the current stock price is less that the current fundamental value of the stock then an investor would gain if he takes a long position of the stock as the price of the stock will eventually converge to its fundamental value. Conversely, in case if a stock is overvalued then investor should take short position. Answer 3 The strong form of efficient market hypothesis indicates that current stock price reflects all available information, private or public. There have been many studies which explores the strong form of efficiency. Calendar anomalies Researchers have found seasonal patterns and one of the well documented anomalies is the week-end effect. They found that stock returns were negative over the period from close of Friday to opening of Monday. January effect is another calendar anomaly. They found that in January stock prices seem to rise more in any other month of the year. Figure 1: January effect (Source: Chandra, 2008, p. 427) The above figure shows the average return of US stocks from 1926 to 1983. There are several explanations for explanation of January effect. First is that in the first few weeks of January, many information is revealed about the firms. Second, investors sell the stocks on which they have lost money during December for tax benefit from capital loss and then they buy back them in January. Third is that there are huge inflows to portfolios around the turn of the year. All these explanations provide partial explanations while the January still remains an important anomaly. Conclusion Efficient market hypothesis is an important part in finance. According to efficient market hypothesis it is not possible to predict the stock price fluctuations. There have been many studies regarding the difficulty in beating equity market. It is not possible for investors to find trends in the stock prices and beat the market. Past performance did not influence stock prices else the investors would have earned abnormal profits easily. In weak form of efficient market hypothesis, stock prices reflect market trading data and information derived from it. There are many tests to confirm this. Further under weak form of efficient market hypothesis, fundamental analysis might generate abnormal profits. There have been many studies under strong form of efficient market hypothesis. Calendar anomalies reflect one such study which researchers have studied. References Chandra, P. 2008. Financial Management. London: McGraw-Hill Education. Kothari, S.P. 2001. “Capital markets research in accounting”, Journal of Accounting and Economics. Vol. 31(2), pp. 121-130 Raghunathan, V. and Rajib, P. 2007. Stock Exchanges, Investments and Derivatives: Straight Answers to 250 Nagging Questions. London: McGraw-Hill Education Sollis, R. 2012. Empirical Finance for Finance and Banking. New Jersey: John Wiley & Sons Read More