3 ways of creating valuable financing opportunity:
Investors lack an understanding of the risk and valuation of complex securities
Reduce costs or increase subsidies
Create a new security
What is an efficient market? What is the EMH?
An efficient capital market is one in which share prices fully reflect available information. In an efficient market, share prices will immediately adjust to new information. This is known as the efficient market hypothesis (EMH) and has implications for investors and for firms:
Awareness of information when it is released does an investor no good. The price adjusts before the investor has time to trade on it.
Valuable financing opportunities that arise from fooling investors are unavailable in efficient markets.
3 Foundations of Efficient Markets (by Andrei Schliefer):
a) Rationality: Imagine that all investors are rational. When new information is released in the market place, all investors will adjust their estimates of share prices in a rational way.
b) Independent Deviations from Rationality: Investors may not react rationally to the release of new information but suppose that about as many individuals were irrationally optimistic as were irrationally pessimistic; prices would be likely to rise in a manner consistent with market efficiency, even though most investors would be classified as less than fully rational.
c) Arbitrage: Arbitrage generates profit from the simultaneous purchase and sale of different, but substitute, securities.
To handle differential response rates of price changes, researchers separate 'information' into 3 different types:
1. Information about past prices
2. Publicly available information
3. All information
Different Types of Efficiency:
1. The Weak Form: A capital market is said to be weakly efficient or to satisfy weak form efficiency if it fully incorporates the information on past share prices, making it predictable. If it were possible to make extraordinary profits simply by finding patterns in share price movements, everyone would do it, and any profits would disappear in the scramble
2. Semi-Strong Form: A market is semi-strong form efficient if prices reflect (incorporate) all publicly available information, including information such as published accounting statements for the firm as well as historical price information.
3. Strong Form: A market is strong form efficient if prices reflect all information, public or private.
Hence, strong form efficiency implies semi-strong form efficiency, and semi-strong efficiency implies weak form efficiency
In practice, arbitrage is defined more casually as a strategy that exploits market inefficiency and generates superior returns if and when prices return to their fundamental values. The arbitrageur earns a profit by buying low and selling high and waiting for prices to converge to fundamentals (also called convergence trading).
What are the limits to arbitrage?
1. Trading costs can be significant and some trades are difficult to execute
2. Arbitrage trading can be done by short selling. To sell a stock short, you borrow shares from another investor’s portfolio, sell them, and then wait hopefully until the price falls and you can buy the stock back for less than you sold it for. Such strategies can be very rewarding, but they are rarely risk-free.
What are the empirical challenges to market efficiency?
1. Limits to Arbitrage: Short selling is highly risky.
2. Earnings Surprise: In reality, it has been shown by Kolasinski and Li (2005) by ranking US companies by the extent of their earnings surprise that prices adjust slowly to the earnings announcements. While market efficiency implies that prices will adjust immediately to the announcement.
3. Size: In practice, it has been shown that the average return on small stocks is quite a bit higher than the average return on large equities. Although much of the differential performance is merely compensation for the extra risk of small firms, researchers have generally argued that not all of it can be explained by risk differences.
4. Value vs. Growth: A number of papers have argued that equities with high book-value-to-share-price ratios and/or high earnings-to-price ratios (generally called value stocks) outperform equities with low ratios (growth stocks). In every country, with the exception of Germany and Switzerland, value stocks outperformed growth stocks.
5. Crashes and Bubbles: Bubbles can result when prices rise rapidly, and more and more investors join the game on the assumption that prices will continue to rise. These bubbles can be self-sustaining for a while, but eventually prices fall back to their original level, causing great losses for investors.
Behavioural Finance: People are not 100% rational 100% of the time.
Two psychological principles of behavioural finance: representativeness and conservatism.
Representativeness: Psychologists have found that, when judging possible future outcomes, individuals tend to look back at what happened in a few similar situations. As a result, they are led to place too much weight on a small number of recent events. Financial economists have argued that representativeness leads to overreaction in share price returns.
Conservatism: This principle states that individuals adjust their beliefs too slowly to new information. People tend to update their beliefs in the correct direction but the magnitude of the change is less than rationality would require. A market composed of this type of investor would probably lead to share prices that underreact in the presence of new information.