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Prof. Avner Kalay - Investments Pure Efficiency is impossible - - $100 on the ground If the markets are totally efficient prices reflect all available information Therefore there are no returns on information acquisition. There will be no costly collection of information So why would prices reflect the new information? Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form - - Weak forms: These test attempt to find out if one can make abnormal profits by following investment strategy that uses only the history of prices. An investment strategy based on technical analysis would be evidence of inefficiency in the weak form. Early tests show that there is not much value in charts. Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form - - - The Weekend effect – Prices on close of Friday higher than open on Monday. The difference is smaller than the transaction costs. January effect – the return of small firms during the first week of January are abnormally high. The phenomenon appeared in Australia where the tax year is different Data Snooping Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? - - Kalay and Wohl (2009). Informed traders are more sensitive to market prices than uninformed. Hence there is information in the shape of the demand and supply curve during the opening session at the TASE. If the demand (supply) curve is steeper than the supply (demand), the stock price is likely to go down (up) from the opening to the closing. Prof. Avner Kalay - Investments The Idea Three informed investors and liquidity traders. Investor 1 excess demand: q1 = 10 – p Investor 2 excess demand: q2 = 12 – p Investor 3 excess demand: q3 = 14 – p We break the excess demand of strategic investors to demand and supply. Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? 14 12 10 Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? 15 14 Price 13 D 12 S 11 10 9 0 1 2 3 4 5 Quantity 6 7 8 9 Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? •At the equilibrium price of $12 investor 3 buys 2 units from investor 1 while investor 2 stay out of the market. •Now introduce asymmetric presence of liquidity traders. Liquidity supply of 1 unit and liquidity demand of 2 units. Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? 16 15 14 Price 13 D 12 S 11 10 9 8 0 1 2 3 4 5 quantity 6 7 8 9 Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? •The larger presence of liquidity buys push the equilibrium price to $12.333. •At this price investor 1 supplies 2.333, investors 2 supplies 0.333 and investor 3 demands 1.666. •Only one strategic investor buys while two are selling. Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? - The economic value is still $12 hence we expect a price drop. KW (2009) measure the relative slope of the demand and the supply and use it to predict the return during the day Flatter supply (demand) -- informed are selling (buying) and prices will drop Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? M= |slope of the demand|/ [slope of the supply + |slope of the demand|] Without the liquidity traders M = 1/{1+1} = 1/2 With more liquidity buyers M = 1/{1+2}=1/3 Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? Rj,t,open to close = j + j Mopen,t + t=1,2,..,167 days j = 1,2,..,105 stocks Average = 2.349 with t of 29.83 Average adjusted R square = 0.139 j,t Prof. Avner Kalay - Investments Tests of Market Efficiency – Weak Form? - Can one make money using this model? Not clear. We used all the information in the limit order book while the market has only the most extreme three. Knowing the book is valuable. Prof. Avner Kalay - Investments The book Orders to Sell 100 at $106 70 at $105.9 80 at $105.8 Orders to Buy 95 at $105.6 110 at $105.4 200 at $105.1 Prof. Avner Kalay - Investments Earnings momentum Stock returns E↑ Event time E↓