Question

1.      Market efficiency                                                                       (5 marks)

a. Identify and describe the three forms of market efficiency. Do not use more than five sentences for each form of market efficiency. Make sure your descriptions discuss information dispersion and identification of mispriced securities.   (4 marks)                                                                                                                                         

b.      Based on your knowledge and understanding of the three forms of market efficiency, which form do you think most appropriately describes the Toronto Stock Exchange? Explain your answer.

Answer 1

Weak Form

In the weak-form efficient market hypothesis, all historical prices of securities have already been reflected in the market prices of securities. In other words, technicians – those trading on analysis of historical trading information – should earn no abnormal returns. Research has shown that this is likely the case in developed markets, but less developed markets may still offer the opportunity to profit from technical analysis.

Semi-strong Form

In a semi-strong-form efficient market, prices reflect all publicly known and available information, including all historical price information. Under this assumption, analyzing any public financial disclosures made by a company to determine a stock’s intrinsic value would be futile since every detail would be taken into account in the stock’s market price. Similarly, an investor could not earn consistent abnormal returns by acting on surprise announcements since the market would quickly react to the new information.

Strong Form

In a strong-form efficient market, security prices fully reflect both public and private information. Therefore, insiders could not generate abnormal returns by trading on private information because it would already figure into market prices. Researchers find that markets are generally not strong-form efficient as abnormal profits can be earned when nonpublic information is used.

Weak Form Efficiency on the Toronto Stock Exchange:

A financial market is efficient when market prices reflect all available information about value. The more efficient the market, the more random the sequence of price changes generated by such a market; and the most efficient market of all is a market in which price changes are completely random. Thus, if the number of patterns identified in the real price series is the same as in simulated price data, then technical analysis cannot be gainfully applied and the weak form of the efficient market hypothesis cannot be rejected.

We adopt the following notation throughout the report: P (R) i,t , t = 0..Ti - adjusted daily close prices for stocks listed on the TSX, where i refers to each individual security, and (R) denotes original data series. P (S) i,t , t = 0..Ti - adjusted daily close prices for stocks listed on the TSX, where i refers to each individual security, and (S) denotes simulated data series. P (R) i,0 - beginning or base price r (R) i,t , t = 0..Ti - log return series for security i where Ti is the number of return observations for security i.