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The Capital Markets andMarket Efficiency
Group 1
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The notion that science, left to itself, is bound toevolve more and more of the truth about the world
is another illusion, for science can never existoutside a society, and that society, whether
deliberately or unconsciously, directs its course.
- Northrop Frye
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OutlineIntroduction
Role of the capital markets
Efficient market hypothesis
Technical Analysis
Fundamental Analysis
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IntroductionCapital market theory springs from the
notion that:
People like return
People do not like risk
Dispersion around expected return is a
reasonable measure of risk
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Role of the Capital MarketsDefinition
Economic function
Continuous pricing function
Fair price function
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DefinitionCapital markets trade securities with lives
of more than one year
Examples of capital markets
New York Stock Exchange (NYSE)
American Stock Exchange (AMEX) Chicago Board of Trade
Chicago Board Options Exchange (CBOE)
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Economic FunctionThe economic function of capital markets
facilitates the transfer of money from savers
to borrowers E.g., mortgages, Treasury bonds, corporate
stocks and bonds
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Continuous Pricing FunctionThecontinuous pricing function of capital
markets means prices are available moment
by moment Continuous prices are an advantage to investors
Investors are less confident in their ability toget a quick quotation for securities that do not
trade often
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Fair Price FunctionThefair price function of capital markets
means that an investor can trust the
financial system The function removes the fear of buying orselling at an unreasonable price
The more participants and the more formal themarketplace, the greater the likelihood that thebuyer is getting a fair price
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Efficient Market HypothesisDefinition
Types of efficiency
Weak form
Semi-strong form
Strong form
Semi-efficient market hypothesis
Security prices and random walks
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Types of EfficiencyOperational efficiency measures how well
things function in terms of speed of
execution and accuracy It is a function of the number of order that are
lost or filled incorrectly
It is a function of the elapsed time between the
receipt of an order and its execution
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Types of Efficiency (contd)Informational efficiency is a measure of
how quickly and accurately the market
reacts to new information It relates directly to the EMH
The market is informationally very efficient
Security prices adjust rapidly and accurately to newinformation
The market is still not completely efficient
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Weak FormDefinition
Charting
Runs test
Technical Analysis
Fundamental Analysis
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DefinitionThe weak form of the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past The current price is a fair one that considers
any information contained in the past price data
Charting techniques or of no use in predicting
stock prices
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Definition (contd)Example
Which stock is a better buy?
Stock A
Stock B
Current Stock Price
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Definition (contd)Example (contd)
Solution: According to the weak form of the EMH,neither stock is a better buy, since the current price
already reflects all past information.
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ChartingPeople who study charts aretechnical
analysts orchartists
Chartists look for patterns in a sequence ofstock prices
Many chartists have a behavioral element
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Runs TestAruns test is a nonparametric statistical
technique to test the likelihood that a series
of price movements occurred by chance Arun is an uninterrupted sequence of the sameobservation
A runs test calculates the number of ways an
observed number of runs could occur given therelative number of different observations andthe probability of this number
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Conducting A Runs Test
1 2
1 2
1 2 1 2 1 2
21 2 1 2
1 2
where number of runs
21
2 (2 )
( 1)
, number of observations in each category
standard normal variable
R xZ
R
n nx
n n
n n n n n n
n n n n
n n
Z
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Semi-Strong FormThe semi-strong form of the EMH states
that security prices fully reflect all publicly
available information E.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.
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Semi-Strong Form (contd)Academic research supports the semi-strong
form of the EMH by investigating various
corporate announcements, such as: Stock splits
Cash dividends
Stock dividends
This means investor are seldom going tobeat the market by analyzing public news
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Strong FormThe strong form of the EMH states that
security prices fully reflect all public and
private informationThis means even corporate insiders cannot
make abnormal profits by using inside
information Inside information is information not available
to the general public
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Semi-Efficient
Market HypothesisThesemi-efficient market hypothesis
(SEMH) states that the market prices some
stocks more efficiently than others Less well-known companies are less efficiently
priced
The market may be tiered
A security pecking order may exist
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Security Prices and
Random WalksThe unexpected portion of news follows a
random walk
News arrives randomly and security pricesadjust to the arrival of the news
We cannot forecast specifics of the news very
accurately
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Technical analysis is a financial term used to
denote a security analysis discipline for
forecasting the direction of prices through the
study of past market data, primarily price and
volume. Behavioural economic and quantitive
analysis incorporate technical analysis, whichbeing an aspect of active management stands in
contradiction to much of modern portfolio theory.
The efficacy of both technical and fundamental
analysis is disputed by efficient-market
hypothesis which states that stock market prices
are essentially unpredictable.
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Fundamental Analysis
Based upon the belief that stock market values
reflect economic values. And that there is
publicly available information that will allow
them to form a better estimate of value than is
contained in market prices. If there is information (examples?) that will
allow an analyst to form a better estimate of
future dividends (or cash flow) than themarket's estimate, as reflected in current price,
then there may be money to be made.
In liquid, standard markets, its not too likely.
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