Finance

Summary for Foundations of Finance Theory

Summary for Statistic for Finance

Brief of Foundations of Finance Theory

Efficient Market Hypothesis

1. Weak Form, prices reflect all past market level (price and volume) information
   • The weak form of the EMH states that it is impossible to predict future stock prices by analysing prices prices from the past.
   • A run test is test for Weak Form EMH. This is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance.
2. Semi Strong Form, prices also reflect all publicly available fundamental company and economic information. The investors are seldom going to win the market by analysing public news. For example: past stock prices, economic reports, brokerage firm recommendations, investment advisory letters.
   • Corporate announcement such as stock splits, cash dividends, stock dividends.
   • Event study is the test of abnormal return for he associated event.
     1. Collect a sample of firms that have a surprise announcement
     2. Determine the precise day of the announcement and designate this day as zero
     3. Define the period to be studied
     4. For each of the firms in the sample, compute the return on each of the days being studied
     5. Compute the abnormal return for each of the days being studied in the sample
     6. Compute for each day in the event period the average abnormal return for all the firms in the sample
     7. Often the individual day’s abnormal return is added together to compute the cumulative abnormal return from the beginning of the period.
3. Strong Form of EMH states that security prices fully reflect all relevant public and private information. This means that corporate insiders cannot make abnormal profits by using inside information about their company. Inside information is information that are not available to the general public.
   • Examining the performance of professionally managed investment funds
     1. Some funds appear to outperform simple stock indexes on a consistent basis
     2. Early interpretations of this evidence suggested persistent skill in active management
     3. More recent studies suggest that controlling properly for risk (and not just stock index-related risk) shows that these funds earn returns consistent with the risk associated with following mechanical styles and do not have persistent stock selection skills (e.g. Carhart JF97)
     4. Some recent evidence of stock selection ability (Wermers, JF2000, pp.1655-1703)