short-selling restrictions

According The Reference material I uploaded.The Question:Discuss the rationale and main criticisms of short-selling restrictions.Requirement: Instructions:Follow the formatting of this document: font size 12, 1.5 line space, “normal” margin.Answer to each question is about 1 full page long (or at least 1 page, but do not exceed that length too much). Answers that are too short will not get full credit. Bibliography, graphs, and tables are not counted toward main text. Include them at the end of each essay.Bullet points copied from lecture slides are not accepted; you need to expand and explain them in details. Please think carefully and write your answers in a clear and logical way. Also for most questions, you want to support your arguments using dataCopying other people’s work is considered as plagiarism and will be penalized.Format of external citations:Example for in-text journal publications: “Chevalier & Ellison (J. Finance, 1999) found that the funds whose managers attended colleges with higher-SAT scores performed better.” You do not need to provide the full citation of this paper.Example for citing online articles: “In 2014, 85% of active large-cap stock funds failed to beat or match their benchmark index[1].”No need to cite the lecture slides.
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Stock Market Efficiency
Information in Stock P rices
? Wh a t we le a rne d b e fore :
? F or a pub lic ly tra de d firm , m a rke t pric e s h ould
a lre a dy provide ve ry a c c ura te inform a tion
re g a rding th e true va lue of its s h a re s .
? Wh e n ne ws a b out future c a s h flows or c os t of
c a pita l c om e s in, a va lua tion m ode l s uc h a s DC F
ca n be a pplie d to update our expectation.
? If the information is unexpected, market price could diverge from
diverge from fair value temporarily.
2
Market Efficiency
Information in Stock Prices
? Public information: available to all investors, includes
information in news reports, financial statements,
corporate press releases, or other public data sources.
? Private information
3
Market Efficiency
Efficient Markets Hypothesis (EMH)
? In a well-regulated, liquid and developed market, stock
prices reflect ALL available information, and are perfect
indicators of true value.
? Securities with equivalent risk should have the same
expected return (“no arbitrage”)
? Prices adjust to the arrival of new information
instantaneously; “Smart money” drives price to true value
? Information is digested and traded immediately
4
Market Efficiency
Efficient Markets Hypothesis
? In 1970 Eugene Fama defined EMH in 3 levels
? Weak-, semistrong- and strong- form market efficiency
? Different assumptions regarding the information reflected in stock
prices
? Proponents of modern portfolio theory generally in favor of
EMH, while behavioral economists and value investors argue
against it.
5
Market Efficiency
Implications of EMH
? Efficient markets do NOT mean
? You can’t make money
? Investors cannot earn a positive return in the stock market
? You will be protected from wrong choices
? You don’t have to diversify
6
Market Efficiency
Implications of EMH
? They do mean
? On average, you will earn a return that is appropriate for the risk
undertaken
? You should not be able to earn “abnormal” or “excess” returns
? Can’t beat the market => invest in index funds
? “Trust the market, not people”
7
Market Efficiency
EMH & Asset Bubbles
? Asset bubble occurs when the price of an asset grows to exceed
the intrinsic value of the asset
? It is difficult to identify an asset bubble while one is occurring, and they are
generally only recognized after the fact once the bubble has burst.
? Proponents of EMH:
? Price run-up and subsequent burst are due to changes in external factors
such as recessions, and are not necessarily irrational or in violation of EMH
? Behavioral:
? Bubbles may occur due to cognitive biases of investors such as
overconfidence and herd-following behavior.
8
Market Efficiency
EMH& Out-performance of Value
Stocks
? Value investing focuses on purchasing underpriced securities,
including stocks trade at discount to book value, or with low
price/book ratios
? Established by Benjamin Graham (“Security Analysis”, 1934),
made famous by Warren Buffet.
? Value investors: market neglect value stocks while chasing the
high-glam growth stocks, bidding prices too high.
? Proponents of EMH: value stocks are riskier and therefore
demands a risk premium
9
Market Efficiency
Information in Stock Prices
10
Market Efficiency
Weak Form Efficiency
? If the market is weak form efficient:
? Prices reflect all past market information such as price
and volume
? Investors cannot earn abnormal returns using past price
movements and volume data to predict future direction
of stock prices.
? Technical analysis has no value as a trading strategy
(cannot lead to abnormal returns).
11
Market Efficiency
Empirical evidence for Weak Form
Efficiency
? Test: if there are patterns in past prices
? No pattern- indicates that markets are generally weak form efficient)
? Early evidence
? No predictable pattern in stock prices; successive price changes are
generally random (~ zero correlation between stocks prices today and
tomorrow, like a “random walk” process)
12
Market Efficiency
Random Walk & Brownian Motion
13
Market Efficiency
Empirical evidence for Weak Form
Efficiency
? More recent studies shows evidence of weak form inefficiency.
? Jegadeesh and Titman (1993): winners outperform losers in the short run
(short-term momentum), most significantly over the next 6 months
? De Bondt and Thaler (1985): losers outperform winners over long-term
horizon (next 36 months), consistent with overreaction followed by
correction.
14
Market Efficiency
15
Market Efficiency
Technical Analysis and EMH
? Technical analysis:
? Relies on past market information to forecast future direction of
prices
? Believes that investors are emotionally driven and predictable,
which can be exploited.
? Methods vary greatly, sometimes contradicting predictions
? Warren Buffet: “I realized technical analysis didn’t work when I turned
the charts upside down and didn’t get different answer.”
? Many technical trading rules have never been empirically
tested; so it is possible that they might lead to abnormal
returns.
16
Market Efficiency
17
Market Efficiency
Semi-strong Form Efficiency
? If the market is semi-strong form efficient
? Prices reflect all publicly available information including trading
information, annual reports, press releases, etc.
? Stock price responds immediately to u n e xp e c te d news
? Investors cannot earn abnormal returns by trading on public news
releases
? Implies that fundamental analysis will not lead to abnormal returns
? Semi-strong form efficiency implies weak form, but not vice
versa
18
Market Efficiency
Fundamental Analysis and EMH
? Fundamental analysis
? Attempts to predict the intrinsic value of an investment
? Relies on publically available information to identify firms that are
worth more (or less) than everyone else’s estimate of the values.
? E.g., DCF, valuation ratios
19
Market Efficiency
Empirical Evidence of Semi-strong Form
Efficiency
? Tests: how security prices react to unexpected news or
announcements (using event studies)
? Is new public information rap id ly reflected in market prices? Can
investors profit from public information?
? Empirical evidence suggests that larger, more closely followed
stocks are more likely to be semi-strong form efficient; small,
more thinly traded stocks may not be semi-strong form
efficient, but liquidity costs may wipe out any abnormal returns
that are available.
20
Market Efficiency
Testing Semi-strong Form EMH
21
Market Efficiency
Empirical Evidence of Semi-strong
Form Efficiency
? Most event study results support the semi-strong form of
efficiency, that prices immed iately reflect information from
news and announcements, for example, to takeover
announcement, corporate reorganizations, stock splits.
? For earnings surprises, found evidence of positive or negative
abnormal returns continuing for a couple months after the
earnings announcement!
? Long-run abnormal returns also found after IPOs, share
repurchase announcements, etc.
? “Anomalies”- calendar effects, size effects, value effects.
22
Market Efficiency
Price Response to Takeover
Announcement
23
Market Efficiency
Strong Form Efficiency
? Prices reflect ALL information, including public and private
? Investors could not earn abnormal returns regardless of the
information they possessed
? Strong form efficiency implies semi-strong form, but not vice
versa
? Testing strong form efficiency (if private information can lead to
profit) is difficult since it’s hard to observe private information
? Usually examine the information available to corporate insiders
(officers, directors)
24
Market Efficiency
Strong Form Efficiency
? Empirical evidence indicates that markets are NOT strong form
efficient: insiders could earn abnormal returns
? Insider trading is prohibited by law
? E.g., Martha Stewart case
? Public companies are required to disclose monthly reports of
every purchase and sale of shares by officers and directors
25
Market Efficiency
EMH and Portfolio Management
Strategy
? Passive or active management
? Active: security analysis; timing
? Passive: buy and hold; index funds
? Even if the market is efficient, we might still need portfolio
management, due to risk level management, tax, etc.
? If the market is efficient, it would be better off to buy index
fund, then who is going to search for information?
26
Market Efficiency
Grossman-Stiglitz Theorem
? There are two types of investors:
? Uninformed: liquidity or noise traders; do not do research
? Informed: spend time and money to dig up information no
one else has, until marginal benefit = marginal cost
? Informed investors make the market efficient for the
uninformed (that’s why we need professionals).
27
Market Efficiency
Grossman-Stiglitz Theorem
? In equilibrium, investors should earn the same return
investing in a passive index fund, as in an actively managed
fund (after research, transaction costs).
? If active portfolio managers fail to use information properly,
or have excessive transaction costs, they could do worse than
a passive portfolio.
? (Evidence) Since 2008, most actively managed funds haven’t
beaten the market, but many still believe that at certain times,
and for certain strategies, actively managed funds are superior
to index funds.
28
Market Efficiency
Short-Selling & EMH
? Short-selling is a method of profiting when a stock declines in
value.
? The sale of a security that is not owned by the seller, or that the
seller has borrowed, with the intention of repurchasing them at a
lower price.
? Ex. Stock SS is trading at $50. Trader believes price will decline, and so
the trader borrows 100 shares and sells them. Trader is now “short” of 100
shares of SS.
? Price of SS drops to $45, and trader buys 100 shares to replace the
borrowed shares. Ends with a profit of $500, excluding commissions and
interest.
29
Market Efficiency
Short-Selling Restrictions
? When large, speculative short-sale bets accumulate against a stock
or other financial asset, the price can be driven down.
? Short sales were among the causes blamed for rapid price declines
in Lehman Brother’s stock price prior to its bankruptcy.
? On 9/19/2008 the SEC placed a temporary ban of short-selling stocks of
financial institutions, to 10/8/2008.
? The action was based on the view that short selling in a crisis market
undermines confidence in financial institutions and erodes their stability.
? UK regulators announced a temporary ban on short-selling of financial
stocks on 9/18/2008.
30
Market Efficiency
Short Selling: Evil?
? Alessandro Beber &Marco Pagano analyzed the effect of these
bans in 30 countries from January 2008 through June 2009.
? Concluded bans disrupted trading by widening bid-ask spreads
? The evidence shows that short selling serves a useful social purpose.
Without the presence of short sellers, we may have overpriced.
? SEC:
? (September 2008) “The emergency order temporarily banning short selling
of financial stocks will restore equilibrium to markets.”
? (December 2008) “Knowing what we know now, I believe on balance the
commission would not do it again. The costs (of the short-selling ban on
financials) appear to outweigh the benefits.”
Short Selling: Evil?
? Short-selling is a reflection of investor believe or opinion
? Could help resolve mispricing of assets, and enhance efficiency
? Bans slows down the reflection of news or information in stock
prices, especially for small-cap stocks.
? Bans excludes bearish investors who do not own the stocks, and
therefore their valuation is not reflected in stock prices.
General Lessons of EMH
? Empirical tests show that efficient markets theory is a half-
truth: it is difficult but not impossible for some people to beat
the market. If you are curious and diligent finding investment
opportunities, you can beat others.
? Counter-arguments say that there could be flaws in the tests
? What does SEC think about EMH?
? Has some faith in it
? They regulate the flow of information to make sure it’s an
even play ground for everyone
33
Market Efficiency

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