The Analysis of Economic Time Series - Term Paper Example

MSc Finance MSc Accounting Module: Corporate Finance Deadline: 11th December, 2006 This essay is 40% of total assessment, so please try your best to get higher mark. If you fail this essay you won't get the second chance to write this. Instructions ANSWER ALL QUESTIONS Efficient Markets Hypothesis i. Drawing from the seminal work of Fama (1970,1991),explain the Efficiency Markets Hypothesis (10 marks) ii. On the basis of general experience, discuss the validity of Efficient Markets Hypothesis for stock markets (30 marks) Your answer which should not be more than 2500 words in length should provide: a) a comprehensive literature review relating to the Efficient Markets Hypothesis b) Do stock markets behave in the way as implied by the theory Note: marks will be awarded for evidence of effective research and good referencing Please follow the instructions listed above and check again. The most important thing is to answer the questions above, but poor referencing will lose mark as well. There are some parts obviously didn't use Harvard Reference System. Eg: work cited, and citation in text http://www.leeds.ac.uk/library/training/referencing/ This webpage may help you to do Harvard referencing. Efficient Market Hypothesis Introduction It was not until the late 1960s and early 1970s that a fully-developed, empirically-supported theory of share prices' behavior emerged in the form of the Efficient Markets Hypothesis (EMH).Prior to the development of the EMH, analysts assumed some degree of dependence across successful price changes. A lot many efforts were made towards identifying a predictable trading pattern which could be used for chasing profitable deals. From the mid-1950s to the early 1980s, a random walk theory (RWT) of share prices was developed based on the past empirical evidence of randomness in share price movements. RWT basically stated that speculative price changes were independent and identically distributed, so that the past price data had no predictive power for future share price movements. RWT also stated that the distribution of price changes from transaction to transaction had finite variance. In addition, if transactions were fairly uniformly spread across time and were large in numbers, then the Central Limit Theorem suggested that the price changes would be normally distributed. (Please check your citation by using Harvard system http://www.leeds.ac.uk/library/training/referencing/text.htm#indirect ) Kendall (1953) calculated the first differences of twenty-two different speculative price series at weekly intervals from 486 to 2,387 terms. He concluded that the random changes from one term to the next were large and obfuscated any systematic effect which may be present. In fact, he stated that 'the data behaved almost like a wandering series' (random walk) (its not required here-check the way author has been cited) Specifically, an analysis of share price movement revealed little serial correlation, with the conclusion that there was very little predictability of movements in share prices for a week ahead without extraneous information. Subsequently the pattern of market levels was generated and changes akin to real levels and changes in the Dow Jones Industrial Index. It also estimated the probability of different share price movements over time by using a frequency distribution of historical changes in the weekly market index, and assumed weekly changes were independently drawn from a normal distribution with a mean of + 0.5 and a standard deviation of 5.0.Subsequent conclusion was that changes in security prices behaved as if they had been generated by a simple chance model .The fundamental concept behind random walk theory is that competition in perfect markets would remove excess economic profits, except from those parties who exercised some degree of market monopoly. This meant that a trader with specialized information about future events could profit from the monopolistic access to information, but that fundamental and technical analysts who rely on past information should not expect to have speculative gains. (Please follow the instructions to revise, introduction is an example. Make sure all questions have been answered. And the reference is good. Thank you.) Literature Review From the empirical evidence and theory of random walks arose the theory of efficient markets. Fama (1970, 1976) gives out the details of the early literature on both the theoretical and empirical foundations of the Efficient Markets Hypothesis, whilst Cuthbertson (1996) summarizes the latest research developments. While EMH has empirical findings in respect of aspects like market perfection and information availability when combined with practices like trading platform and transaction costs may produce only marginal and well calculated opportunities for speculative gains; many other economists have quoted the existence of stock market bubbles. A bubble is generally defined by the economists as a deviation from stock market fundamentals; whereas Kindleberger reckons a bubble as an upward price movement over an extended range that tends to implode (Kindleberger ,1996). By the same analogy an extended negative bubble is a crash. The existence of such situations has immediate learning points for an investor. Financial theory, taught in finance textbooks the globe over, normally exposes a student of finance to the concepts like the efficient market hypothesis and the economically rational individual. Bubbles and crashes seem to defy these two seminal concepts with an awkwardness equivalent to the awkwardness one would attach to those things on earth that defy gravity. Nevertheless such extreme stock market movements are a reality. Bubbles make investing decisions arduous as stock prices tend to deviate by substantial margins from their fundamental valuations. Investors relying on past company results and technical analysis are equally defeated in such situations as is the EMH.In fact, investors always act on the basis that they have an applicable construct to explain stock price movements and tend to input all available information collected under such constructs in their investment decisions (Poole, 2000). Finance research has also held varying opinions on this issue.For instance, Biermann (1995) supports the idea that market prices are determined from backward looking investors than by those that indulge in predictions of all sorts. Others have, for example elaborated on the use of price to earnings ratios to determine excess market valuations. Some technical work has set to rest in a convincing manner the phenomenon of bubbles and bursts. For instance, Graham (1973) describes in details why markets fluctuate and how to deal with the violent fluctuations .Graham discusses five basic points to read into cross sectional view of market bubbles. Most of these points concern factors like growth and earnings and their impact on price movements and price levels. Graham(1973) ,in fact, provides a much better viewpoint on gauging market bubbles through an adaptive expectations model. Efficient Market Hypothesis From the theory of random walks arose the theory of efficient markets. The Efficient Markets Hypothesis (EMH) states that current prices always 'fully reflect' available information, so that the only reason prices change between time t and time t+1 is the arrival of new information. The EMH requires that only two necessary conditions be met. First, the market must be aware of all available information .The type of information available is determined by the strength of the EMH being tested. In a Weak Form EMH, current prices entirely reflect all that can be known from the study of historical prices and trading volumes. If the Weak Form is valid, technical analysis becomes ineffective. Any information contained in past prices has been analyzed and acted on by the market, so that shares are neither under-valued nor over-valued. In a Semi- Strong EMH, current prices efficiently adjust to information that is publicly available. If this form of the hypothesis holds true, then fundamental as well as technical analysis is also ineffective because all publicly available information has been thoroughly analyzed, assessed and acted upon. Finally, in a Strong Form EMH, current prices fully reflect all information, and not just that information which is to be found in the historical trading pattern or available publicly. Thus, if the Strong Form holds true, any attempt to make profitable use of monopolistic access to information is useless because this information has already been incorporated into the market price of the share. The second necessary condition is that of the rational expectations element of the EMH, or informational efficiency. It means that real returns can be randomly higher or lesser than expected returns, but on average, unexpected returns must be zero. The main implication of the rational expectations is that no system of trading rules can have higher expected returns than the equilibrium expected returns derived by the market. In other words in a perfect market scenario of RWT and varying degrees of market perfection in 3 forms of hypotheses under EMH the prices determined are efficient and there is no incentive on the market to either change prices or move away from equilibrium prices until unless some new unabsorbed information/event comes about making it necessary to move towards a new equilibrium. Forms of efficiency The three forms of efficiency postulated in the EMH have already been stated in their theoretical form as above. To reiterate, in a Weak Form efficient market, current prices fully reflect what is knowable from the study of historical prices and trading data. Thus, future prices will tend to maintain the pattern of historical prices and will not deviate from such historical trends substantially.Bubbles and bursts are ruled out in such a scenario.Market has determinate information which is an extenuation of the information available till the recent past. If the Weak Form is valid, technical analysis becomes ineffective as it would not reveal any information that has already not been discounted in stock prices. All information contained in past prices has been analyzed and utilized by the market, so that shares are neither under-valued nor over-valued. In a Semi- Strong Form efficient market, current prices efficiently adjust to information that is publicly available. Therefore, the present stock prices would have discounted all such available public informatio.Such information,which is publicly available, includes earnings announcements, investments, dividends and capitalization changes. If this form of the hypothesis holds true, then fundamental as well as technical analysis are rendered of little use for the investor because all publicly available information has been thoroughly analyzed, assessed and discounted into investing decisions by an array of analysts and treasury operators. Finally, in a Strong Form efficient market, prevailing stock prices fully reflect all information, not just that included in the historical trading pattern of the stock or available through publicly released financial and other statements by the company. Thus, if the Strong Form holds true, any attempt to make profitable use of monopolistic access to information is useless because this information has already been incorporated into the market price of the share. Thus the three forms of EMH simply fulcrum on the degrees of information available and stipulate the amount of leverage available to the investors. Validity The Efficient Markets Hypothesis (EMH) posits that present stock prices always 'fully reflect' available information, so that the only possibility or factor which makes for a price change of stock, between time t and time t+1, is the arrival of 'news' or unanticipated events. However this is assuming away a lot of inconvenient reality. In real stock market situations there are transactions costs, information is collected and analyzed by an expensive system of analysts and information is priced and carries a cost and the reactions to a piece of information vary across a wide range of investors. However the EMH is based on the assumptions of zero transaction costs, freely available information and an agreement among investors on the implications of information on the share price. As Fama (1970)states, these conditions do not hold in the real stock market situations. However the fact that these assumptions may not come true in real life situations does not affect the validity of the EMH. For instance, the market can still be efficient if a sufficiently large number of traders have access to the necessary information. This is quite true in active lobbies of traders. A deviation from this access pattern-often results in the notorious insider trading charges. Insider trading is a situation wherein select market operatives have access to sensitive information pertaining to a stock and they use it to reap speculative gains. This is often seen in situations where a market operator has built sufficient and controlling buys in the market of a takeover target on the sly. In such a scenario the market is not aware of the takeover by a highly rated corporate-whereas a select band of market operators are aware of it and build buy positions to take advantage of the future rise in stock prices. Thus, whilst these conditions are sufficient, they are not necessary. The EMH requires that only two necessary conditions be met. First, the market must be aware of all available information. Theoretically stated, this means that the information set used by the market in time t to determine the price of security at time t is equivalent to the true information set. The type of information contained in the information set is determined by the strength of the EMH being tested. The second necessary condition states that the market correctly uses the available information in assessing the expected return of the share in the future period. These aspects pertain to rational expectations and informational efficiency.However the EMH has been stated to contain a logical flaw. The American economists Grossman and Stiglitz explored the issue in 1980 .Their findings were published in an article "On the Impossibility of Informationally Efficient Markets" in the American Economic Review. Their point was that markets cannot be efficient by accident. If they are efficient, then it is because of information and research. These activities have costs, but there is no incentive to pay for this research unless it can be used to make higher returns. In a truly efficient ( frictionless and costless) market all information would be incorporated in the market price eliminating any profit opportunities. The long run theories of adaptive expectations and rational expectations do offer sufficient explanation of the wild fluctuations often seen in stock prices as they dangerously defy their fundamental foundations and worth. Simply put, one can ask a question -if the stock market has been observed to have a long term average growth rate of 6% per year, then under what conditions do indices like S & P 500 exhibit stock prices rise many multiple times this long term average growth rate These staggering variations in price valuation are so astounding that traditional models,seeped in neat theory, have a difficulty explaining them (Poole 2000).A plausible explanation of such volatile market behaviour has been offered through the theoretical construct of herd mentality. Herd mentality essentially refers t the investor behaviour pattern wherein the customers tend to develop a core market sentiment and attract most part of the market in following this core sentiment like sheep in herds. In such situations naturally a downward or an upward swing gets accentuated and theorists keep opining that random walk seems to be drifting one way or the other. Thus if most investors followed what others did, the volatility in stock valuation might be explained. As Keynes said: A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of the sudden fluctuation of opinion due to factors which do not really make much difference in the prospective yield (Shiller, 2000). As the confidence in the market increases, investors will drive the prices away from the fundamentals (Diba ,1990). In short, while the early literature contained potent arguments in favour of market efficiency;the latter market developments and theoretical probing as questioned the neatness inherent in the EMH .This literature ,while acknowledging departures from the random walk with drift and explaining with relevant drift models of stock price movements, concluded that in economic terms these deviations were insignificant, so that the 'fair game' property of the EMH was not disturbed. Fama (1991) state that, "any test of asset pricing models runs into the joint-hypothesis problem. Thus we can never know whether the market is inefficient or the model is wrong. Obviously, the choice of model may influence the findingsand that. For US stocks the relation between Beta and expected returns is feeble even when Beta is the only explanatory variable. This is less so when the data is expanded to include bonds." Conclusion While there is wide acceptance that the stock market is weak form and strong form efficient, it has not been feasible or possible to produce specific theoretical constructs or models of the behaviour of share prices across time. Most theorists also agree that information affecting stock price movements is rather randomly generated and reaches the markets equally randomly-until unless vaulted and planned in insider trading situations or with some strategic intents. Given these features determining the efficiency level of the market leaves one with, at best, a fundamental random model. The swings or drift characteristic is a little more difficult to explain; however, it just goes on to point the fact that values increase across time to reflect the return element that is, in turn, determined by the choice to invest in a risky asset. Please use Harvard System to do referencing Works Cited (Obviously you didn't use Harvard System) KENDALL, M.G.1953. The Analysis of Economic Time-Series - Part 1: Prices. Journal of Royal Statistical Society, vol.96, pp.11-25. FAMA, E.F. 1970.Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance. vol.25, no.2, pp.383-417. FAMA, E.F. 1976. Foundations of Finance. New York: Basic Books. CUTHBERTSON, K.1996 .Quantitative Financial Economics: Stocks, Bonds and Foreign Exchange. England: John Wiley and Sons. KINDLEBERGER, CHARLES P. 1996.Manias, Panics, and Crashes. 4ed. New York: John Wiley and Sons, Inc. BIERMAN JR, HAROLD.1995.Bubbles, Theory, and Market Timing. Journal of Portfolio Management 22.1 : 54-61. GRAHAM, BENJAMIN.1973. The Intelligent Investor. 4 ed. New York: Harper & Row. POOLE, WILLIAM.2000.Expectations. Twenty-second Henry Thorton Lecture. 28 November 2000. SHILLER, ROBERT J.2000. Irrational Exuberance. New York: Broadway Books. DIBA, BEHZAD T.1990.Bubbles and Stock-Price Volatility. The Stock Market: Bubbles, Volatility, and Chaos. Norwel, MA: Kluwer Academic Publishers. EUGENE FAMA.1991.Efficient Capital Markets II. Journal of Finance. December 1991. Read More