Investment Analysis & Portfolio Management’s Assignment

Dr. Ika Pratiwi Simbolon, S.E., M.M.

Written by:
Group 2:

Erika Victoria (014201800092)

Florentia Tiurma Puspita Manik (014201800115)
Gao Xinyu (014201800125)
Gao Yahao (014201800120)
Gladys Kerenhapukh Toti (014201800042)
Zhang Ruizhao (014201800127)
 QUESTION

1. Discuss the rationale for expecting an efficient capital market. What factor would you
look for to differentiate the market efficiency for two alternative stocks?

2. What is meant by the term abnormal rate of return?

3. Define and discuss the semi strong-form EMH.

4. Define and discuss the weak-form EMH.

ANSWER

1. There are several reasons why one would expect capital markets to be efficient:
- The foremost being that there are a large number of independent, profit-maximizing
investors engaged in the analysis and valuation of securities.
- A second assumption is that new information comes to the market in a random
fashion.
- The third assumption is that the numerous profit maximizing investors will adjust
security prices rapidly to reflect this new information. Thus, price changes would be
independent and random.
- Finally, because stock prices reflect all information, one would expect prevailing
prices to reflect “true” current value.

Capital markets as a whole are generally expected to be efficient, but the markets for
some securities might not be as efficient as others. Recall that markets are expected to
be efficient because there are a large number of investors who receive new information
and analyze its effect on security values. If there is a difference in the number of analysts
following a stock and the volume of trading, one could conceive of differences in the
efficiency of the markets.
 For example, new information regarding actively traded stocks such as IBM and Exxon is
well publicized and numerous analysts evaluate the effect. Therefore, one should expect
the prices for these stocks to adjust rapidly and fully reflect the new information. On the
other hand, new information regarding a stock with a small number of stockholders and
low trading volume will not be as well publicized and few analysts follow such firms.
Therefore, prices may not adjust as rapidly to new information and the possibility of
finding a temporarily undervalued stock are also greater.

Some also argue that the size of the firms is another factor to differentiate the
efficiency of stocks. Specifically, it is believed that the markets for stocks of small firms
are less efficient than that of large firms.

2. Abnormal rate of return or alpha is the difference between the return the portfolio
actually produced and the expected return given its risk level or a security’s return differs
from the expected rate of return based upon the market’s rate of return and the security’s
relationship with the market. It is a measure of performance on a risk-adjusted basis.

3. The semi strong-form efficient market hypothesis contends that security prices adjust
rapidly to the release of all new public information and that stock prices reflect all public
information. The semi strong-form goes beyond the weak-form because it includes all
market and also all nonmarket public information such as stock splits, economic news,
political news, etc. Investors cannot utilize either technical or fundamental analysis to
gain higher returns in the market. Those who subscribe to this version of the theory
believe that only information that is not readily available to the public can help investors
boost their returns to a performance level above that of the general market.

Using the organization developed by Fama, studies of the semi strong-form EMH can be
divided into two groups:

(1) Studies that attempt to predict futures rates of return using publicly available
information (goes beyond weak-form EMH). These studies involve either time-series
analysis of returns or the cross-section distribution of returns.
 (2) Event studies that examine abnormal rates of return surrounding specific event or
item of public information. These studies determine whether it is possible to make
average risk-adjusted profits by acting after the information is made public.

4. The weak-form efficient market hypothesis explains that stock prices reflect all past
information available in the market such as price data, trading volume, or short interest.
Past trade data is available on the market and does not require a fee to get it. All investors
will try to take advantage by reading data patterns from past data if the past data contains
reliable signals about future results. The implication is that all investors will exploit the
signal so that the signal will lose its value and will immediately be reflected in the price.

No form of technical analysis can be effectively utilized to aid investors in making

trading decisions. Advocates for the weak form efficiency theory believe that
if fundamental analysis is used, undervalued and overvalued stocks can be determined,
and investors can research companies' financial statements to increase their chances of
making higher-than-market-average profits.

The two groups of tests of the weak-form EMH are:

(1) Statistical tests of independence and

(2) Tests of trading rules.

Statistical tests of independence can be divided further into two groups: the
autocorrelation tests and the runs tests. The autocorrelation tests are used to test the
existence of significant correlation, whether positive or negative, of price changes on a
particular day with a series of consecutive previous days. The runs tests examine the
sequence of positive and negative changes in a series and attempt to determine the
existence of a pattern.

In the trading rule studies, the second major set of tests, investigators attempted to
examine alternative technical trading rules through simulation. The trading rule studies
compared the risk-return results derived from the simulations, including transaction costs,
to results obtained from a simple buy-and-hold policy.