Question

1.

a) For each of the three versions of market efficiency (weak, semi-strong, and strong) give an example of a stock price movement (can be real or hypothetical) that would NOT be consistent with that version of efficiency.

b) What sorts of factors might limit the ability of rational investors to take advantage of any pricing errors that result from the actions of “behavioral investors”?

Answer 1

a.) Market Efficiency debate is about how quickly the information is incorporated into the price.

• Weak form of efficiency claims that information takes some time to get reflected in price, but all past information is reflected. Hence, money cannot be made using technical analysis i.e. by studying past price movements. Thus, if there is relation between past and present/future price of stock, this will be inconsistent with weak market efficiency.
• Semi Strong form of efficiency claims that all public information is incorporated into price immediately. No money can be made using fundamental analysis or technical analysis. Hence, PEAD which stands for Post Earnings Announcement Drift meaning even after release of information to public - financial statements, reports etc, stock prices take time to adjust to new equilibrium and hence money can be made even for some time (usually 3-4 weeks) after the public announcement of information. Thus PEAD is inconsistent with Semi-strong market efficiency.
• Strong form of efficiency says all information be it public or private is reflected in stock prices. Hence, all investments in a strong efficiency market are zero NPV investments. Thus, insider trading profits are a violation of strong efficiency. Since, movement of market is as expected by trader using insider information and hence all private information is not reflected in price since an insider can take advantage of it. Also, strong form of efficiency imples profits exceeding normal returns cannot be earned regardless of amount of information or research and hence investors making profits higher than normal returns depict inconsistency with strong form of market efficiency.

b.) Factors that might limit the ability of rational investors to take advantage of any pricing errors that result from the actions of "behavioral investors" are -

1. No fixed time horizon for correction - Over/under pricing of securities usually gets worse before it gets better, and there is no fixed time horizon when market will correct itself and hence it can go on and on. Examples are - the US housing bubble, overpricing of NASDAQ index in late 1990s and so on.
2. Limits to short selling and associated inherent costs - In India and other markets, there are limits to short selling fixed by government and also the associated costs with shorting the stock (margin requirements and so on) are high. Thus, this limits arbitrage opportunities and therefore the power of arbitrage to bring security prices to their intrinsic values.
3. Model Risk - Rational investors by virtue of their rationality are aware that no perfect models exists for pricing securities. Models are ever evolving and no single model fits all requirements. Thus, they are aware that the perceived mispricing may be a result of their faulty model than the entire market being wrong.