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Challenge to the market efficiency hypothesis
Challenge to the market efficiency hypothesis
Challenge to the market efficiency hypothesis
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We make the following assumption regarding the probability distributions of risky asset returns: Returns are jointly normally distributed random variables which is the reason that investors can focus only on mean and variance of the returns(Fama and French 2004). This implies all portfolios created from a combination of individual assets or other portfolios must have distributions that continue to be determined by their means and variances. A portfolio of assets whose returns are multivariate normally distributed also has a return that is normally distributed.
The Mean Variance Optimization model was derived from the portfolio theory by Markowitz(1952). There are several assumptions have been used when deriving this mmedel. Firstly, The mean of historical returns is used to show the expected return, the variance of these returns is used to show the risk which comprise systematic risk and unsystematic risk(Ross, Westerfield and Jordan 2008). Secondly, ‘the process that generates returns in the past is also the process that generates returns in the future’
(Frino, Hill and Chen 2009). Thirdly, all investors are rational and risk-averse, and expect higher return along with higher risk (Fame and French 2004). Fourthly, the Mean Variance Optimization model is assumed in a single period, so initially an investor creates a portfolio according to the chosen meanvariance-criterion and keeps the proportion of assets in the portfolio unchanged last to end of the period (Korn and Korn 2001). Lastly, all investors are price takers so their invesment decisions do not affect price, also there is no income tax or transaction fee.
CAPM model shares many assumptions with Mean Variance Optimization model since it is derived from Markowitz’s mean-...
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...e approach. EU Socrates Project. MaMaEuSch-Management Mathematics for European Schools, 2001. http://optimierung.mathematik.uni-kl.de/mamaeusch/
Markowitz, H.M. Portfolio Selection. Journal of Finance.1952, 7 (1): 77–91.
Ross, S. A., Westerfield, R. W. and Jordan, B. D. Corporate finance fundamentals. New York: McGraw-Hill/Irwin, 2008.
Bodie, Z., Kane, A., Marcu, A. J. Investments 9th ed. New York: McGraw-Hill/Irwin, 2008.
Fama, E. F. and French, K. R. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives. 2004, 18 (3): 25-46.
Chamberlain, G., & Rothschild, M. (1984). Arbitrage, factor structure, and mean-variance analysis on large asset markets.
Talor, B 2006, Developing Portfolio Optimization Models, Mathworks, viewed 21 May 2014,
http://www.mathworks.com.au/company/newsletters/articles/developing-portfolio-optimization-models.html
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
Financial market link to the real economy. Very often the markets are sensitive to many variables for example of most efficient managers with a SAT score above 1420, however according to “Chevalier and Ellison's manager characteristics model can explain only about 5% of the total variation in mutual fund returns” (James L. Davis), because the style-adjusted passive benchmark model has proved to be more efficient in work of the average mutual fund than the active one (James L. Davis).
William Sharpe, Gordon J. Alexander, Jeffrey W Bailey. Investments. Prentice Hall; 6 edition, October 20, 1998
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
Capital Asset Pricing Model is believed to be the first equilibrium asset pricing model t...
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
Asset allocation decisions made by an investor are considered more important than other decisions such as market timing or security selection. In the research provided by Hensel (1991), performance attribution is one of the main components when choosing the right assets in a portfolio. The impact of any investment decision can be measured by comparing its outcome with the outcome of some alternative decision. Furthermore, according to Hensel (1991), every investor has to incorporate the minimum-risk portfolio, which is a combination of securities or asset classes that reduces the uncertainty of future portfolio returns to a minimum.
4. Most investors have multi-period objectives and the mean-variance framework is a single period model.
Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence. Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund. As the market rises so will the investors returns since historically the market continues to rise as a whole.
The efficient market hypothesis has been one of the main topics of academic finance research. The efficient market hypotheses also know as the joint hypothesis problem, asserts that financial markets lack solid hard information in making decisions. Efficient market hypothesis claims it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information . According to efficient market hypothesis stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments . In reality once cannot always achieve returns in excess of average market return on a risk-adjusted basis. They have been numerous arguments against the efficient market hypothesis. Some researches point out the fact financial theories are subjective, in other words they are ideas that try to explain how markets work and behave.
Investment portfolio policies can be categorized as either active or passive investment strategies. It is essential to all active strategies for the requirement of expectations about the factors, which is influenced on the performance of an asset class. In this case active equity management, this may include of future earnings, dividends and price-earnings ratio. In relations to active bond strategies, it may involve forecasts of future interest rates, interest-rate risk and yield spreads, and involving in foreign securities will require forecasts of future exchange rates. However, passive strategies can be classified minimum expectation output and one common type of this strategy is indexing, which objective is to replicate the performance of a preset index fund or benchmark.
Stock market prediction is the method of predicting the price of a company’s stock. It is believed that stock price is lead by random walk hypothesis. Random walk hypothesis states that stock market price matures randomly and hence can’t be predicted. Pesaran (2003) states that it is often argued that if stock markets are efficient then it should not be possible to predict stock returns. In fact, it is easily seen that stock market returns will be non-predictable only if market efficiency is combined with risk neutrality. On the other hand it is also been concluded that using variance ratio tests long horizon stock market returns can be predicted....
Block, S. B., & Hirt, G. A. (2005). Foundations of financial management. (11th ed.). New York: McGraw-Hill.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.