Capital Markets Assignment

Michal Piwowarczyk 07025505
Anthony Foster 07022568

Atanas Iwanow 07010516
£ukasz Kwiatkowski 07013160
Bartosz Koziñski 07016375
Gregory Bondaruk 07007926
The definition of an efficient stock market is that share prices rationally reflect all the
available information. Furthermore, by definition, in an efficient market there is little
possibility for the individual trader to achieve abnormal profits (Arnold, 2008) through any
method other than chance. The quote “If stock market experts were so expert, they would
be buying stock, not selling advice.” by Norman Augustine enables us to develop a
discussion concerning market efficiency but also analysis of its anomalies and
inefficiencies. Those inefficiencies in the long run will transform into anomalies like for
instance mispricing. In general anomalous pricing can be viewed with scepticism, even
when they are persistent, other factors may inhibit their usefulness.
Firstly it will be beneficial to explain the essence of market efficiency, its use and
limitations to full market efficiency. Market efficiency is related to informational efficiency.
If new information becomes available about a stock (change in earnings), an industry
(change in demand), or the economy (change in expected growth), an efficient market will
reflect that information in a few minutes, even a few seconds. However, if only half of that
information is reflected in the stock price immediately and the remaining half takes
several days, then the market is less than fully efficient. The compelling idea about market
efficiency is that if too many know about an inefficiency that may be exploited they will act
in the same way. As a result the price of stock will reflect new information more quickly and
in this way the inefficiency will disappear. Market efficiency affects constituents such as
investors, companies, governments and consumers. If investors find that prices are
predictable, then smart investors can earn extra returns at the expense of naive or
unsophisticated investors. This will make the latter reluctant to invest and overall the
supply of capital will be limited. Governments are interested in market efficiency because
of its implications on economic growth because of the allocation of resources and supply
of capital and also because the speculative inefficiency 'bubbles' have proven to be
damaging to the entire economy (Japan's stock market and real estate bubble in the
1980s). Companies on the other hand can learn from the stock markets, if they are
efficient aggregators of information (mergers being rejected by tepid reception by the
market). Limiting factors to a fully efficient market can be summarised as cost of
information, cost of trading and limits of arbitrage. In an article aptly titled “On the
Impossibility of Informationally Efficient Markets,” Sandy Grossman and Joe Stiglitz
prove that if markets are efficient then they instantaneously reflect new information in
prices. If it is so then no investor will be interested in generating new information because
its value will be zero (information is only valuable when it helps decision making). The
implication of this is that markets can't be fully efficient because no one has the incentive
to make them so.
Market participants must be compensated in some way for making the market more
efficient. Like the cost of information, traders incur costs while trading: their time,
brokerage costs, and other related costs. One factor that can have a large influence on
prices is the difficulty in short selling. If short selling, that is, selling a stock that you do not
own is more difficult than buying long, that is, buying a stock that you do not own then
prices are likely to be biased upward. In essence the greater the trading cost, the greater
the mispricing.
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There are also limits to arbitrage (taking advantage of price differential between two
markets). The first is the uncertainty regarding the time when the mispricing will disappear.
The second one is the fact that it is hard to find assets with exactly the same level of risk.
The third and most important is the limited supply of capital. As agents, arbitrageurs must
abide by the constraints imposed on them by the owners of capital (the principals).
As Benjamine Friedman noted, “there is no coincidence that the research conducted in

support of EMH has emerged entirely from the nation's business schools” and that “from
their perspective of private-interest orientation of this institutions this understanding is
appropriate and understandable”. According to Stern, Friedman is correct in the idea that
the idea of efficiency arose in business schools, it has been noted that businessmen and
MBA students have been much receptive to the idea that there is “gold in the streets” than
to the lesson that fiercely competitive markets eliminate the easy opportunity for gain. In
fact, the research done till now has been performed mostly by statisticians. But statistics
usually lack an economic explanation which could possibly be inferred but not validated in
any other way. As it was noted by Vijay Singal; “Since anomalies are predictable patterns in
returns a person who studies hundreds of different relationships and millions of different
observations is likely to find a pattern”. This is called data mining.
In this sense, an anomaly can be discovered as long as there is a large enough number of a
possible relationships and enough tries. Another source of unreliability of an anomaly is the
so-called survivorship bias (Singal, 2003). For example a study of mutual funds might
suggest that they outperform their benchmarks. The issue here is that only well-performing
funds survive so the sample might exclude under-performing ones. Mispricing can be also
caused by 'small sample' bias. According to Singal '2a selection' bias can creep in when the
results arise from a certain part of the sample but seem to be representative of the entire
market”. The example given to prove the latter statement is the January effect. The author
states that the January effect is not wide-spread but it is due to firms that are of small size.
Once the small firms are removed from the sample the January effect disappears.
If you construct a portfolio of such inactively traded stocks, then it will seem that these
stocks have predictable returns—that is, the stock price will change in accordance with the
market, but with a delay. As it was noted though the reason for the anomaly actually also
affects the exploitation of it; the stocks are not tradable because as soon as somebody
wants to trade the excess return will not be realized due to the market reaction. Of course,
the mispricing anomalies which emerge have much more credibility when there is a
rational explanation for their emergence. As Vinjal notes many anomalies emerge as a
result of government regulation e.g. January effect. The explanation of this effect is based
on the tax-loss selling by investors in December to realize capital losses that are used to
offset capital gains. When the selling pressure abates in January, the loser stocks
appreciate.
2
We have said that it is possible for anomalies to exist in capital markets and that they can be
caused by inefficiencies in the market, i.e. poor information. From here it is important to
note that these anomalies, although known to exist, cannot be exploited in the long-run
simply because of the extensive knowledge of their existence. Traders are aware of them
and their trading behaviour will therefore reflect their existence causing any potential
benefits to disappear.
The persistence of anomalies has become a major area of interest, however the reasons
behind their persistence remains mostly speculative and are specific to the anomaly under
scrutiny. Fama (1998) argues that a mispricing anomaly can persist because agency
problems associated with professional money managers, along with transactions costs,
can cause mispricing to persist and that many anomalies are a result of such market
frictions. However, Singal (2003) suggests that the mispricing anomaly is either an under
or overreaction to information which would imply that mispricing is completely random and
occurs only by chance.
As we have analysed market efficiencies and inefficiencies with their anomalies we can
now comment on Norman Augustine's quote. His quote has both a grain of truth and some
imperfections.
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Let us start with the imperfections. First of all, we have to take into account the fact that
some stock market experts do not have enough capital in order to put their trading
strategies into life. In order to speculate the market and relatively control it, such an expert
would need billions of dollars. Therefore as most of those experts have rather limited
budget they have to sell their advice to others. Another, slightly related imperfection is that
an unscrupulous trader may be in a position to take advantage of his clients, or to even
manipulate the market to suit his own ends. The main idea of selling advice is that
professional traders can benefit both from commissions made from advising clients and by
trading in securities themselves. Obviously a trader is primarily in business to increase his
own wealth therefore any information passed on by traders must be held at arms length.
That said it may well be in the trader's best interest to have successful clients as this could
attract more clients and more potential commission. For example; if a trading company
were to build successful portfolios then they may increase their reputation and ultimately
increase their client base. Therefore, as they sell the same advice to more and more
customers the capital that they can, to some extent, control increases.
For instance if they were to advise a client to buy a particular security, they may
inadvertently be attracting attention by giving this recommendation which could in turn
affect the price of the security. Should they attract sufficient attention, and many investors
may buy it, they may drive the share price up. During this time an expert who will give this
recommendation buys the same share from its own private capital. As the share price goes
up he sells his shares at or close to the rate of return that he set as a goal. After it, he could
advise some of his more important customers to sell, which will result in share price fall. As
this example shows, if an expert has a good reputation, even with limited profits it is
possible for him to earn much higher returns than he would if he had traded without selling
his advice. Also experts usually have greater knowledge concerning market inefficiencies.
So they can take more advantage of them. Another important point is the fact that experts
usually are better informed and receive information from the market faster than others. This
can enable them to make better foundations for their analysis, which will result in better
advice. What goes along with is the fact that they can sell advice at a certain complexity to
their customers. For instance if the expert has some inside information, he cannot disclose
it to the public directly as it would be against the law. However, he can sell advice which will
only suggest what to buy and when. Hence the expert will earn commission from his/her
customer profits without risking breaking the law(see Appendix).
As experts are humans they make mistakes. So if they would try to implement their ideas
and trading strategies to the market and turn out to be wrong they would lose most of it. As
they are selling advice their risk spreads as they control a particular share price to some
extent. Consequently experts can try to pursue more aggressive strategies on clients who
seek high rate of return and risk only small proportion of their own capital to take advantage
of economies of scale.
4
Example of profiting from misinformation caused by experts could be seen on Warsaw

Stock Exchange few months ago(October 2008). The major polish petrochemical
company PKN ORLEN received the recommendation from JP Morgan that due to
problems with one of their refineries the true value of their shares is about 10PLN. On the
day of publishing this recommendation the value of one share was 27.50PLN. Within next
three days the price dropped by 18.5% to 22.40PLN per share. As it reached this level JP
Morgan put the information on the market that new recommendation is that the price shall
be as it was as the company dealt with the refinery problem very fast and good and the true
value of the share is about 27PLN. This recommendation was published late afternoon just
few minutes before the Stock Exchange closed on Friday (24.10.2008). Next Monday
(27.10.2008) the price started to rise and till Friday reached 28.00PLN per share (25%
increase). As we have looked at the Stock Exchange analysis program it showed that
someone bought a vast number of PKN ORLEN shares in the exact moment the
recommendation was announced. Therefore it would not be hard for JP Morgan to use
such misinformation to make profits for them and their customers.
To summarize the flaws of this statement we would say that the most important thing that
was failed to notice in this quote is the fact that experts have limited capital. Therefore they
are unable to use their knowledge as efficiently, as they use it while selling advice. Hence
they would not be able to earn as much as they do when selling their advice. What is more
they can use their expert position to make suggestions for the market in order to produce
profits for them.
Some other major assumptions made by an efficient market are that all information is
perfect and freely available to all traders. In reality companies endeavour to retain sensitive
information that could affect their share prices, unless it is in their interests to see price
movements. Also, information on the market cannot be assumed to be wholly up-to-date as
the very nature of Norman Augustine's famous quote suggests the idea that if information
on the market did exist it would already have been exploited sufficiently enough to
neutralise the advantage before you heard it. Arnold (2007) gives an analogy of this notion
by recalling a university lecturer explaining that if the £20 note (that one of his students just
found in the hallway) really existed it would already have been picked up by someone else.
In conclusion we have established that an efficient market share prices reflect all available
information perfectly. However Norman Augustines quote about experts selling advice is
an illustration to the contrary as, by the nature of the statement, market experts choose not
to make their money solely by trading. This suggests that a market will never be wholly
efficient, and our analysis of anomalies coincides with this. We have enough evidence to
suggest that abnormal profits can only be achieved by chance, or by insider trading, as
companies are reluctant to release ALL information. Some information may be held simply
because of the implications it may have on the company. Conversely, some information in
the market may be old, false or inaccurate making accurate exploitation impossible.
Finally, it must be said that by nature as humans we will always 'look after number one' and
any information available which may suggest abnormal profits can safely be assumed to
be wrong.
5
BIBLIOGRAPHY:
Fama, E (1998) Journal of Financial Economics 49, Market efficiency, long-term returns, and
behavioural finance
Singal Vijay, 2003, BEYOND THE RANDOM WALK: A Guide to Stock Market Anomalies and
Low-Risk Investing., Oxford University Press
Arnold Glen, 2008, Corporate Financial Management 4th edition, Prentice Hall
Arnold Glen, 2007, Essentials of Corporate Financial Management, Prentice Hall
ISPAG, Warsaw Stock Exchange Analysis Software
Mills, T C and Coutts, J A (1995), "Calendar Effects in the London FT-SE Indices", The
European Journal
of Finance, 1, 79-93.
Arsad, Z and Coutts, J A (1996) "The Weekend Effect, Good news, Bad News and The
Financial Times Industrial Ordinary Shares Index: 1935-1994", Applied Economics Letters, 3,
797-801.
Arsad, Z and Coutts, J A (1997), "The Trading Month anomaly in the Financial Times Industrial
Ordinary Shares Index: 1935-1994", Applied Economics Letters, 3, 297-299.
Arsad, Z and Coutts, J A (1997), "Security Price Anomalies in the London International Stock
Exchange: A sixty year Perspective", Applied Financial Economics, 7, 455-464.
Coutts, J A and Hayes, P (1999), "The Weekend Effect, The Stock Exchange Account and The
Financial Times Industrial Ordinary Shares Index: 1987-1994", Applied Financial Economics, 9,
67-71.
Coutts, J A (1999), "Friday the Thirteenth and the Financial Times Industrial Ordinary Shares
Index 1935-94", Applied Economics Letters, 6, 35-37.
Cheung, K -C and Coutts, J A (1999) "The January Effect and Monthly Seasonality in the Hang
Seng Index: 1985-1997", Applied Economics Letters, 6, 121-123.
Coutts, J A and Sheikh, M A (2000), "The January Effect and Monthly Seasonality in the All Gold
Index on the Johannesburg Stock Exchange 1987-1997", Applied Economics Letters, 7, 489-
492.
Coutts, J A, Kaplanidis, C and Roberts, J (2000), "Security Price Anomalies in an Emerging

Market: The Case of the Athens Stock Exchange", Applied Financial Economics, 10, 561-571.
Coutts, J A and Cheung K -C (2000), "Trading Rules and Stock Returns: Some Preliminary
Short Run Evidence from the Hang Seng 1985-1997", Applied Financial Economics, 10, 579-
586.
Cheung, K -C and Coutts, J A (2001), "A Note on Weak Form Market Efficiency in Security
Prices: Evidence from the Hong Kong Stock Exchange", Applied Economics of Letters, 2001,
8, 407-410.
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Coutts, J A and Sheikh, M A, (2002), "A Note on the Anomalies that Aren't There: The Weekend
and Pre-Holiday Effects on the All Gold Index on the Johannesburg Stock Exchange 1987-
1997", Applied Financial Economics, 12, 863-871.
Stern et al, The Revolution in Corporate Finance, 4Th Edition, Blackwell Publishing, 2003
Michaely R, Womack K.L, Brokerage Recommendations:Stylized Characteristics, Market

Responses, and Biases; Prepared for Advances in Behavioral Finance II edited by Richard
Thaler, Johnson Graduate School of Management, Cornell University, and IDC, 2004
7
APPENDIX:
The most important factor in a efficient market will always be the quality of the information on
which share prices are based. In a perfectly efficient market all share prices are true representations
of their true value based on everyone who influences the price of a share having access to ALL
information available & relevant. In reality, however, this is not always the case. Share prices are
thought to have 3 levels of efficiency, weak, semi-strong and strong (Arnold 2007:229). Weak form
efficiency is common in markets and means that prices are based on historical data. This is very
unreliable and cannot aid prediction of future price movements. Semi-strong form efficiency fully
reflects all publically available information, but does not include privately held information, and, it
is the most common form of efficiency for obvious reasons. Strong form efficiency therefore
reflects all known information (both private & public) and fully reflects a share's true value. The
notion of strong form efficiency obviously forms the basis on which EMH is based, however it is an
ideal and rarely possible in reality. Strong form requires knowledge of private information and
sharing this information could be construed as insider trading, which is illegal.
Some other major assumptions made by an efficient market are that all information is perfect
and freely available to all traders. In reality companies endeavour to retain sensitive information that
could affect their share prices, unless it is in their interests to see price movements. Also, information
on the market cannot be assumed to be wholly up-to-date as the very nature of Norman Augustine's
famous quote suggests the idea that if information on the market did exist it would already have been
exploited sufficiently enough to neutralise the advantage before you heard it. Arnold (2007) gives an
analogy of this notion by recalling a university lecturer explaining that if the £20 note (that one of his
students just found in the hallway) really existed it would already have been picked up by someone
else.
The thick black line represents the strong form of market efficiency as all information is
assimilated into the share price immediately upon creation/discovery. Each of the other lines (A, B,
C & D) exists as there are inefficiencies in the market. For instance A could represent a leak of
private information that was not intended for the public market. This new information has not been
considered in the share price (black line) and so trading occurs outside of the efficient market line.

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Capital Markets Assignment

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Michal Piwowarczyk 07025505

Anthony Foster 07022568

As Benjamine Friedman noted, “there is no coincidence that the research conducted in

Example of profiting from misinformation caused by experts could be seen on Warsaw

Arnold Glen, 2007, Essentials of Corporate Financial Management, Prentice Hall

ISPAG, Warsaw Stock Exchange Analysis Software

Coutts, J A, Kaplanidis, C and Roberts, J (2000), "Security Price Anomalies in an Emerging

Michaely R, Womack K.L, Brokerage Recommendations:Stylized Characteristics, Market

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