Answer to Question #112680 in Economics for Arindam Sarkar

Question

Answer the following questions about trading strategies in efficiently inefficient markets.
(a) Describe and explain the main idea behind the three equity strategies discussed in
class. Why might these strategies profit over the long-term? Why might they not?
(b) Some hedge funds make money by providing liquidity to the market. Discuss.
Support your answer with examples.

Answer 1

a) For convenience, the hypothesis of market efficiency was formulated in three forms: weak, medium, and strong.

1. Weak form: current information takes into account all information about past actions of market participants. That is, the history of transaction prices, quotes, trading volumes is taken into account - in general, all information relating to asset trading. It is generally accepted that developed markets are weakly efficient. This implies the senselessness of using technical analysis - because it is based solely on market history.

2. The average form: in the current prices of assets all publicly available information is taken into account. The average form of GER includes a weak one - after all, market information is publicly available. In addition, information was taken into account on the production and financial activities of companies issuing securities and on the general political and economic situation. That is, all information about the political structure, economic statistics and forecasts, information about corporate profits and dividends are taken into account - everything that can be gleaned from publicly available sources of information.

The average form of GER implies the senselessness of making investment decisions on the basis of new information that has appeared (for example, the publication of the company's financial statements for the next quarter) - this information is taken into account in prices immediately after it became publicly available.

3. Strong form: in current asset prices all information is taken into account both from publicly available and from closed sources. In addition to publicly available, non-public (insider) information is also taken into account, which is available, for example, from the managers of a company regarding the prospects of this company. Strong form includes both weak and medium form. A market that is effective in a strong form can be called perfect - it is understood that in general all information is publicly available, free of charge, and goes to all investors at the same time. In such a market, it is pointless to make investment decisions even on the basis of insider information.

For example, having important information regarding the long-term condition of the company (publication of financial statements, etc.), the investor can make a profit as a result of investing in this company in case of excellent long-term financial stability of this company.

If an investor adheres to the classic “buy and hold” strategy, this does not mean that in the long run he will make a profit, since various factors can influence the market and it is very difficult to make money on a developed market according to this strategy, other strategies need to be developed.

b) In general, the essence of hedge funds is that it is a kind of association of investors who make collective investments - an analogue of the usual investment funds that are created with the aim of increasing investors' funds. However, they have more opportunities for investment, hedge funds can work with stocks and bonds, as well as with currency, futures and options. In addition, through the use of special investment strategies, such a fund is able to make a profit not only in a growing, but also in a falling market.

A short position implies taking a certain amount of shares from a broker on credit for a specified period for a set fee and selling them on the market.

An example of a strategy in a falling market (using a short position).

The fund borrows 1,000 shares of company A from a broker at a price of $ 100. Those. his debt will be $ 100,000 + $ 1,000 broker remuneration for the service. Having received the papers, the fund sells them on the market for $ 100,000. After some time, the market dipped and stocks fell 20%. The fund buys the necessary thousand shares for $ 80,000. After repaying the debt to the broker, the fund still has $ 19,000 in profit ($ 100,000 - $ 80,000 - $ 1,000).

A long position involves the purchase of securities with a growing trend and their subsequent sale at a higher cost.

An example of a strategy in a growing market (using a long position).

The fund buys at its own expense or similarly takes 1000 shares of company B from a broker at a price of $ 60. Those. his debt amount is $ 60,000 + $ 1,000 broker remuneration. Since this is being done on a growing market trend, the fund has been holding securities for some time. Gradually, the market rises, increasing in price and stocks. Let's say their cost increase was 20%. The fund sells its 1,000 shares for $ 72,000. After repaying the debt to the broker, the fund has $ 11,000 in profit ($ 72,000 - $ 60,000 - $ 1,000).

Thus, the hedge fund accumulates money and invests in various instruments, making money on it. By investing, the hedge fund provides markets with money, i.e. liquidity.