Case studies, introduced back in 1969, produced useful evidence on how stock prices react to information. Many studies focus on returns in the short window (several days) about clean of the event. The advantage of this approach is that, because expected daily returns are close to zero, the model for the expected return does not have a major impact on the findings of abnormal returns.
The assumption in studies that focus on short return windows is that there were delays in price response event is short-lived. There is a developing literature that challenges this assumption, arguing instead that stock prices adjust slowly to information, so that one must examine returns over long horizons to show full-size market inefficiency.
If someone said to accept its conclusions, many of the recent studies on long-term returns suggest market inefficiency, namely, long-term under reaction or overreaction to information. It is time, however, to ask whether this literature, viewed as a whole, suggests that the efficiency should be rejected. The answer should be a solid, no, for two reasons.
First, the efficient market generates categories of events that individually suggest that prices are over-react to information. But in an efficient market, it is obvious:
Under-reaction will be around as often as over-reaction. If the anomaly is divided between the accident under-reaction and overreaction, they are consistent with market efficiency. We will see that even clear about the division between overreaction and underreaction is a good description of the menu of existing anomalies.
Second, and more importantly, if the long-term return anomalies are so large that it cannot be attributed to the case, then even split between over-and under-reaction is a Pyrrhic victory for market efficiency. We will find, however, that the long-term return anomalies are sensitive to the methodology. They tend to become marginal or disappear when exposed to different models for expected (normal) returns or when different statistical approaches are used to measure them. Thus, even viewed one by one, most long-term return anomalies can reasonably be attributed to chance.
The problem in the development of the overall perspective of long-term return studies is that they rarely test specific alternative to market efficiency. Instead, the alternative hypothesis is unclear, the market inefficiency. This is unacceptable. Like all models, market efficiency (the hypothesis that prices fully reflect the available information) is a wrong description of the pricing. Following the standard scientific rule, however, market efficiency could be replaced by a better specific model of price formation, itself potentially rejectable by empirical tests.
Each alternative model has a difficult task. Please specify the errors in information processing, which have the same investors under-react to certain types of events and over-reaction to others. The alternative must also clarify the observed results better than the simple story of market efficiency, ie the expected value of abnormal returns is zero, but chance generates deviations from zero (anomalies) in both directions.
From the literature, the irregularity was not settled on a concrete alternative to market efficiency, to get the ball rolling I assume that reasonable alternatives must choose between over-reaction or response. Using this perspective, we review existing studies, without questioning their applications.
Each mechanism of organized marketing assets or financial liabilities is determined on the financial market. It is a market in which financial assets and liabilities are traded (Richard and Bill, 2006). Financial assets in this area includes all forms of securities, ranging from ordinary derivatives. Performance, it is widely used can be seen as “the ability to achieve the desired result of the action or not waste energy” (Encarta Dictionary, 2009). In other words, it has to do with how resources are used efficiently, the extent to which something is good. Financial market efficiency can be said to include as financial assets and liabilities are exchanged efficiently and productively the funds invested in financial market instruments. However, the exchange of securities in respect of funds can not be made only at the price willingly accepted by both parties, while the price is determined mainly by the value and scope of information available on the market for investors. This document discusses the performance of financial markets, however, explore the theories and assumptions, and explaining in detail all the terminology (majorly prices and information) relating to the efficiency of the financial market.
There have been extensive results on the effectiveness of the financial market. This led to the development of various theories, such as determination of the value of securities, the impact of information on share prices, dividend policy, to name a few.
DEFINITION OF FINANCIAL MARKET
Financial markets, as per Olowe, 1997, are mechanisms in which the surplus and deficit units can be connected economy by buying and selling financial claims. Furthermore, he argues that the primary function of financial markets is to allow the funds effectively allocated from the surplus units in the economy, the deficit units for productive investments. Richard and Bill, 2006, view of the financial market, like any market mechanism for financial assets and securities. They further explain that there is often no physical market transactions are conducted via telephone or computer. Is any market in which financial assets and liabilities are traded and the mechanism through which corporate financial managers have access to various funding sources and instruments. Capital markets, however, operate in two ways:
Primary market – providing new capital for enterprises and other activities, usually in the form of issuing shares to new or existing shareholders or loans. It provides the focal points for lenders and borrowers to meet. First of all, new sources of funding is raised in this market.
Secondary market – trade existing securities, thereby allowing investors to supply the existing holdings at will. Active in the secondary market is a prerequisite for efficient primary market and, as no investor will want to stick with investments that cannot be implemented if desired.
Institute of Chartered Accountants of London describes the financial market, with the means provided by the financial system for the creations, care and distribution of financial assets and liabilities. The market according to the institute, has two major segments, money and capital markets.
Money market offers the opportunity to raise short-term investments and funds. Tenor, which from day to day varies from about a year or two years. Exchange financial instruments on the market include treasury bills, bills, treasury certificates, securities, etc., the capital market on the other hand are the mechanisms, institutions and structures in which the medium and long term funds are collected and made available for businesses, government and individuals . Capital markets is that the instruments which are already provided are outstanding.
OVERREACTION AND UNDERREACTION
One of the first papers on long-term return anomalies wrote by DeBondt and Thaler (1985). We find that when stocks are ranked on three to five years past returns, past winners are usually the future losers, and vice versa. Attributed to these long-term return reversals to investor overreaction. In forming expectations, investors give too much weight to past performance of companies and too little to performance instead of the mean return. DeBondt and Thaler seem to argue that the overreaction to past information about the general assessment of behavioral decision theory of Kahneman and Tversky (1982). So could be that the overreaction to the prediction of behavioural finance alternative to market efficiency. In most cases, however, the anomalies literature has not accepted the discipline of an alternative hypothesis.
An exception is Lakonishok et al. (1994). They argue that the indicators of stock prices proxy for past performance. Companies in the high proportion of earnings in the financial market instruments.
These are securities or financial instruments traded on financial markets and the already mentioned, the two major segments of financial markets – money and capital markets, the instruments traded in the money market are as follows:
Treasury securities – those short-term obligations of the federal government to the holder a specified sum of money after a certain number of days in question. Treasury securities are of two types depending on the denomination and maturities. While Treasury yields are generally low fixed and matures about 91 days of issue of certificate treasury share similar features with it, but a longer duration and higher fixed rate.
Certificate of deposit (CDS) – these are the revenues of banks’ deposit liabilities of a specified interest rate for a specified period of time. CDS is an interbank asset and serve as a means of channeling cash surplus of commercial banks, commercial banks, who are the main issuers of these types of devices. When the bank promises to pay the principal and interest at maturity, usually 3-36 months, with the name of the negotiable certificate of deposits. However, if the CD features of the deposit receipt, and are generally held to maturity, while, they are called non-negotiable certificates of deposits. Non-negotiable certificates of deposits is also maturity of up to 3-36 months.
Commercial paper – this is an unsecured short-term bills issued by the company to interested investors for a cash discount for a specific term. Investors in commercial paper loans are usually worth individuals or institutional investors. This is usually for a duration ranging from 30-270 days. Commercial paper dealer, however, classified documents and the documents placed directly. Securities dealer commercial paper investors placed through the dealer, which can be placed directly under a bank notes, commercial papers directly to the investors of the company issuing the documents, which require the issuer to maintain dress trained personnel who have a good knowledge of financial markets and good relationships in the markets. In all cases, the commercial paper investment of the investors, who borrow in the credit market without security, or even negative pledge. Commercial paper traded only on the primary market.
Bankers Acceptances – also known as the draft bill adopted by the drawee bank determines that a certain amount to be paid after a certain period of time. Adopted by writing the word “your” means the whole face of the draft with authorized signature. If this is done, the invoice, you should be the beneficiary of a discount rate. This financing through international trade credits. It is also intended to finance trade in goods in bonded warehouses, and in particular the credit created by the bankers acceptance self-liquid short-term loans. The maturity range of 90-180 days, or sometimes 30 to 270 days.
Bank deposits – this place is the base of the investors / depositors of the bank agreed rate of interest. Bank deposits are divided into call deposits / savings account deposits and fixed deposits. Call made deposits with agreed maturity date, and should be terminated by both parties at any given notice to the other party to an agreement based on the period of notice, the deposit liabilities of deposit and the bank for a specified period a specified rate of interest, which can be fixed or variable. The maturity of deposits vary from a few days a number of years. The deposit must be certified or non-receipt or certificate of deposit.
Derivatives – they are using, or losing or speculation from hedge against movements in currencies and interest rates. These financial instruments whose value are derived from underlying securities, which allows an investor to gain exposure to the performance of the underlying securities without having to physically. If a profit, there may be a hidden risk in derivative markets. Financial experts term “financial weapons of mass destruction,” and describes as hell, which is easy, and almost impossible to quit. Examples of derivatives, forward contracts and contract options for the future.
CAPITAL MARKET INSTRUMENTS
Debt Securities – long-term loans are raised by a company or the government, which interest is payable, and a fixed rate. The nominal value of debt instruments, the debt of the issuer of the instrument and the interest is paid at the nominal rate of interest on this amount. In most cases, debt can be exchanged.
Preference Shares – this is a major source of long-term financing for the company. The holders of traditional shareholders instead of dividends. Preference shares, if they are collectively entitled to the unpaid dividend for the previous periods, carried over from one period to another, until finally paid off, in which case the arrears must be paid before common stock dividends paid. As well as debt securities, preferred shares convertible.
Ordinary Shares – the holders of these shares owned by the company. These nominal values and the memorandum and articles of association of the company’s authorized common shares of the company may issue. The ordinary shareholders of the company’s remaining claims, ie, they paid dividends in other fixed obligations have been met.
Convertible Securities – shares of both of these hybrid securities, the functions of the fixed-income securities and equity. These securities (usually fixed-rate), which is convertible into ordinary shares in the company’s choice of the right in the future.
Having explained the concept of the financial market, and it is composed, it is necessary to examine whether effective or not. Before this can be done, efficiency, whereas a different connotation in different environments should be clarified in the light of the financial market.
This word ‘efficiency’ is all part of the vocabulary of everyone. For most, this means that it can achieve the desired result, without or with minimal wasted energy or effort. The Encarta dictionary, 2009, is the ability to do something well or achieve the desired results will not be wasted energy and effort, that is, to what extent something is done well, or not wasted energy and effort. Overall, this is a situation where growing prosperity of the amount of productive resources and the current state of technical knowledge economy, eliminating wasted effort, and allows for additional output from the available resources to achieve this desired result, avoiding wastage and prevent losses to avoid harm. (David N.H, 2005).
However, in order that the various professions that means different things, “the economists are talking about allocation of efficiency – the extent to which resources are allocated to the most productive use of this society with the greatest need. The engineers talk about the technical efficiency – the extent to which a mechanism performs the maximum capacity. Sociologists and political scientists talk about the social efficiency – the extent to which complies with the accepted mechanism for social and political values. “(Richard and Bill, 2006).
6.1 Financial Market Efficiency
The investment guru or financial expert, a slightly better efficiency, this also applies to the pricing and information on the effectiveness, efficiency, instead of sources of financial market instruments. It is necessary to do a quick and convenient tool to convert currency and vice versa, that the price of the securities is determined and how to manage the risks associated with the securities. This, however, with the roles of the financial market is expected to perform in the economy, according to which the Olowe, 2007, divided into three (3);
- Allocational efficiency – the role of financial markets to optimally allocate scarce savings in productive investments in such a way that benefits everyone.
- The operating efficiency – the server as an intermediary, who provide the funds from savers to investors at the least cost, which offered them a fair return for their services.
- Pricing efficiency – the role of the dominant values at which securities will be replaced if the market price of capital allocation signals. The prices of the forces of supply and demand. Fama, 1976 (the Olowe, 1997) considers the effectiveness of pricing efficiency in the processing of information.
Based on what said before, we can conclude that the pricing information of the two major determinants of efficient financial markets. Thus, financial market efficiency can be defined as the market in which security prices quickly and fully reflects all available information. The market in which any device that outperforms the market to be unusable. Therefore, the efficient financial markets, the same yield for a given level of risk should be implemented for all investors. Price (E / P), cash flow to price (C / P), and the book-to-market equity (BE / ME) is generally poor past earnings growth, and firms with low E / P, C / P, and BE / ME are generally strong earnings growth in the past. Since the market is over-react to the recent growth, it is surprised when earnings growth mean returns. As a result, a high E / P, C / P, and BE / ME stocks (poor past performers) have high future returns, and low E / P, C / P, and BE / ME stocks (strong past performers) at low future returns.
We also considered the poor long-term post-event returns in the stock market (IPO), and experienced their own offerings (SEO) is the overreaction camp. SEO is a strong stock returns in the three years prior to the issue. It seems safe to assume that these strong returns reflect strong earnings. It seems safe to assume that the IPO will have a strong past earnings to appear in public. If the market does not mean that the income growth increasingly means returns, stock prices at the time of the equity issue (IPO or SEO) is too high. If the market only gradually recognizes the mistake, the overreaction to past earnings adjusted for slow growth in the future. Finally, some argue that the long-term negative abnormal stock returns post-list of companies that the new list of the NYSE and Amex because of the overreaction. Companies list their stocks to take advantage of market overreaction to the recent strong performance.
As it turns out, overreaction was the result of tests of long-term returns, market efficiency would be dead, replaced by the alternative behavioural DeBondt and Thaler. The fact that it was obvious during the reaction around frequently.
My grandfather was in the bottom of the reaction to the events of the evidence that stock prices seem to respond to income of about one year after announced. Another impetus to the effect that the high returns of stocks over the past year, yields are typically high, as the next three to six months.
Alternatively, if new tests also produce the long-term post-event abnormal returns, which suggest underreaction, indicating a positive post-event abnormal returns of divesting firms and the companies that will sell. Attributed to the result of market underreaction to the enhanced probability that after the spinoff, both the parent and the spinoff is likely to become merger targets, and the recipient of aid. Desai and Jain and Ikenberry et al. Determine that the companies shared experience in human resources, long-term positive abnormal returns before and after the split. Attributed to the post-split returns to the market underreaction to the information indicates a positive split. Lakonishok and Vermaelen find positive long-term post-event abnormal returns when companies apply for stock. Ikenberry et al. observed similar results in the open market share repurchases. The story in both cases is that while the market, responding to a positive sign for the future performance of the share repurchases.
Finally, Michaely et al. finds that the basis of stock prices, appears to respond to negative information in dividend omissions, information and positive initiatives.
A few of the long-term return anomalies it is not easy to classify. For example, Asquith and Agrawal et al. indicate negative long-term abnormal returns to acquiring firms following mergers. This is also attributable to underreaction of market to a bad investment decision, or overreaction to the typically strong pre-merger performance of acquiring firms, documented, and Mitchell Staford. Ikenberry and Lakonishok find a negative post-event abnormal returns of firms involved in proxy contests.
A story, based on the stock exchange, responds to the poor performance of these businesses prior to the proxy of competition, but another is that the price is too responds to the proxy information that something is likely to change.
Because of the ambiguities in classifying certain disorders, and given the fact that the above review is certainly not complete, I will not do a number against the overreaction underreaction studies. What is important is that the literature does not lean toward the clean up of behavioral alternative to market efficiency. This will not be lost in the behavioral finance researchers who acknowledge the issue:
We hope that future research will help to understand why the market seems to overreact in certain circumstances and underreact in others. (Michaely et al.).
The market efficiency hypothesis is a simple answer to this question is a chance. Specifically, the expected value of zero abnormal returns, but chance generates apparent anomalies that split randomly between underreaction and overreaction.
The weight of evidence of long-term return anomalies are so overwhelming that market efficiency is not viable even in the absence of an alternative working model that explains both under-and overreaction? The answer to that question is no, for two reasons:
First, it is doubtful that the literature is presented in a randomly selected sample of events. Splashy results get more attention, and it encourages you to find. That the dredging of the irregularities of a rewarding profession suggested by the fact that the anomalies literature shows so little sensitivity to the other hypothesis problem. The same authors, visual events are often satisfied with the overreaction or underreaction, and are prepared to conclude that both justify the rejection of market efficiency.
Second, some disorders may be evident by means of a reasonable price. Fama and French find that the long-term return reversals and the DeBondt Thaler, and conversely, to return to the Lakonishok et al. captured by a multifactor asset pricing model. In a nutshell, covariation between the returns of long-term losers seems related to the risk premium, which explains why higher future average returns than long-term winners.
Fama and French discuss the fights and the multifactorial model, but the results are sufficient to illustrate an important point: Conclusions on market efficiency can be sensitive to the assumed model of expected returns.
Last, but most importantly, have more or less split between overreaction and underreaction is not much support for market efficiency in the long-term return anomalies are so great they can not be attributed to chance.
But it will still be viewed individually, most of the anomalies are weak. They usually disappear when reasonable alternative approaches to measure them.
6.2 Pricing of Securities
Pricing is a major determinant of financial market efficiency – security is discussed in relation to pricing of risk and return. Risk, which is created by many factors, such as general economic conditions, economic factors specific to security, competition, technological development, investor preferences, and all other kinds of circumstances, as defined in Van Horne, 1986, the various possible return on investment. Olowe, in 1997, also sees risk to the likelihood of a deviation from the expected return from holding a security back to the actual holding of such securities. The introduction of the risk, the investor may be indifferent as to which to invest in safety, if there is available for investment, similar yields. A conceptual framework for examining the relationship between risk and return, as they affect the pricing of security, discussed the Capital Asset Pricing Model (CAPM) and the discretionary pricing model (APM).
6.3 Capital Asset Pricing Model (CAPM)
This model was developed by Sharpe (1964), Linter (1965) and Mossin (1966). It shows the expected return on the relationship between security and the inevitable risks. Provides a framework for the evaluation of the securities and can be used to find the unit cost of equity capital.
CAPM, however, was the following assumptions:
A time CAPM model assumes that investors are risk averse.
The rice adopters and investors in the securities in the uniform requirement.
There is a risk-free security, so that investors may borrow or loan an unlimited amount of risk premium rates.
The securities are sold, and perfectly divisible. Even more so, to the quantities.
The information is freely available to all investors.
Investment restrictions cannot be neglected and no investor is large enough to affect the market price of the stock.
The above assumptions are briefly assumes that there is a perfect market, and that the financial market is efficient. Thus, as the assumptions, all asset prices fall, that the security market line, while the security market line equation:
E(R1) = RF + [E(RM) – RF]β1
Where β1 = COV(R1RM)
E(R1) = expected return on security
RF = risk – free rate
E(RM) = expected rate on market portfolio
β1 = beta of security i
COV(R1RM)= covariance of return on security i with the returns on a market portfolio.
σ2m = variance of returns on the market portfolio
Example; if the expected return on security is 24% and its beta is 1.8. show whether the security is under or overvalued if the risk – free rate is 13% and return on market portfolio is 18%.
E(R1) = RF + [E(RM) – RF]β1 = 0.13 + [0.18 – 0.13]1.8
0.22 i.e. 22%.
We conclude that it is undervalued as the expected return is 2% less than the predicted. i.e. 24% > 22%.
6.4 Characteristics of CAPM
The fact that not all risk-return safety concern that risk averse investors, asset should be priced to the risk-adjusted return is exactly the security market line. So the only risk is that investors pay a premium to avoid the risk of market share so that the total risk of each security in a systematic and systemic risk. A general and systematic risk affects the entire market, and irregular and the characteristic factors unique to a particular person. Effective diversification, however, reduces the overall risk of the portfolio to the point where only the regular risk remains.
Measured by the weighted average portfolio beta of the beta of individual securities in the portfolio. Proportion of portfolio funds allocated to represent the weights of individual securities in the portfolio, and it represents mathematically:
βP = ∑ wi βi
where βp = beta of portfolio p
βi = beta of security
Wi = proportion of security in portfolio p
Conclusion: CAPM has been derived under some simplifying assumptions, most of which do not correspond to reality. For this reason, it has been criticized on the grounds that it assumes the market portfolio of all assets – stocks, bonds, property and human capital. The real-life situations, empirical tests of the CAPM tend to use proxies, such as stock market indices as the market portfolio.
6.5 The Arbitrage Pricing Model
It has proposed by Rose (1976), because the dissatisfaction of the CAPM on the theoretical and empirical grounds. This is a multi-factor model (multiple-beta model), compared to the CAPM, a single factor model. The safety factor for the actual return for a state grant:
Ri = E(Ri) + ∑ bijFj + ej
This can be restated as Ri = E(Ri) + bi1F1+bi2F2 + ………. + binFn + ei
Ri = actual return on security
E(Ri) = expected return on security i
Fj = the (uncertain) value of factor j
bij = sensitivity to factor j
ei = the error term. It is also the security-specific return.
Similar to the CAPM, we diversify the unsystematic risk, but in addition, we arrive at the market equilibrium, as individuals eliminate arbitrage profits across multiple factors. The model does not explicitly indicate what factors or economic factors or behavioral significance. However, the market return as in the case of CAPM can be one factor. The APM, therefore, suggests that the linear relationship between security returns and a few factors. The steady-state under this model, the expected return on security i E (Ri) issued by:
E(Ri) = Rf +Æ›1 bi1 + Æ›2 bi2 + ……..+ Æ›n bn
Where Rf = risk – free rate
Æ›n = risk premium for the types of risk associated with particular factors. Its equation can be rewritten as: Æ›n = En – Rf
where En is the expected return of a portfolio which has unit response to other factors.
The return of stock company is related to two factors as follows.
E(Ri) = Rf +0.7Æ›1 + 1.6 Æ›2 + 1.3 Æ›3
Where 0.7,1.6 and 1.3 are sensitivity coefficients associated with each factor. If the risk – free rate is 12%, Æ›1 is 7%, Æ›2 is 4% and Æ›3 is 6%. Calculate the expected return on the company’s stock.
E(Ri) = 0.12 + 0.7(0.07) + 1.6(0.04)+1.3(0.06)
= 0.311 i.e. 31.1%
In summary, it seems more than the CAPM, the APM allows the CAPM risk averse investors to focus more attention to the systematic risk of securities pricing and diversify the systematic risk. According to APM on the other hand, individuals across a number of factors arbitrage, arbitrage opportunities disappear when the market is in balance. However, there is consensus on these factors, the APM, and testable. Thus, CAPM can still be used in security prices.
INFORMATION ON SECURITIES
Information can be classified as historic, current, or expected. Only the current or previous information from some of its effect on prices. The more information is available, the better the situation means that an informed decision is more likely correct. Security prices are characterized by a random and unpredictable movements. The movement in security prices may be interpreted to mean that investors in the market, a quick note to all security-related information on prices and prices adjust quickly to such information. Thus, the effectiveness of the security prices depend on the speed of price adjustment to all available information. The more efficient than the speed of adjustment of prices. The market efficiency of the available information, however, the efficient market hypothesis reflects (EMW), the three basic forms:
- Weak form
- Semi – a strong form;
- Strong form.
1) The weak form EMH states that current stock prices fully reflect all of the information included in the recent price movements, which makes it impossible for investors to predict future security prices and the analysis of historical prices, achieved better results than the stock market as well. Therefore, the market may be effective in this form, there is no significant correlation term average prices of securities. Even more so, if an investor’s trading strategy can not beat the market based on information available to him, we conclude that the market is weak form efficient. Olowe 1997, places that most