The market rationality: financial anomalies in efficient markets

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School of Business | Bachelor's thesis
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Degree programme
The main object of the study is to examine the existence of the three most relevant financial anomalies; P/E-, B/M-, and Momentum anomaly and interpret these financial anomalies in the context of efficient markets. The thesis is conducted in the form of a literature review. Anomaly is classified as an abnormal return, which is too extensive and systematic to be ignored. Moreover, it means a deviation from the standard, and by exploiting it, an abnormal return can be achieved. According to traditional economic theory and the Efficient Market theorem states that all available information reflects perfectly to prices of securities, and no one can frequently “beat” markets or receive more returns than the risk level assumes. However, in the case of anomalies, can take advantage of the arbitrage opportunities offered by inefficient pricing and get excessive returns. The Efficient Market theorem is a simplified version of the basic economic theory of competition. The efficient market exists if the three conditions hold, there is no information costs and all investors in the market act rationally. Thus, no one can use the available information to gain excessive returns or beat the market continually. In the context of market efficiency, when investors can earn pure economic profits without costs gathered and use information that allows abnormal returns, its referrers to anomalies. Financial anomalies which are the core of this study, belong to behavioural economics, which criticizes Efficient Market Hypothesis (EMH) introduced by Fama (1970). The EMH states that the future of stock price development cannot be predicted due to the Random Walk model. Moreover, the theory of Random Walk states that changes in stock prices are independent and distributed of each other (i.i.d). The supporters of the behavioural economic have stated that it should be seen rather complementary for the traditional theories than considered as a substitute to it. The paper presents, in addition to the irrational behaviour of investors, also the other reasons for the existence of financial anomalies in the context of EMH. These reasons can be seen as a result of the failure of researchers to formulate either empirical measures of securities price behaviour or theory in efficient markets. These are mainly related to the shortcomings and limitations of the CAPM model. It will be interesting to see in the future whether there is a substitute theorem or model for CAPM and EMH and whether the anomalies decrease or vanish over time and contribute to increasing market efficiency even more.
Thesis advisor
Murto, Pauli
Liski, Matti
market efficiency, EMH, financial anomalies, behavioural economics
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