Level 1 CFA® Exam:
Market Pricing Anomalies
Market pricing anomaly is a situation in which changes in the price of financial instruments may not be explained by information currently available about these instruments. In the market, we can find quite a few anomalies which result in mispricings.
We distinguish among:
- time-series anomalies,
- cross-sectional anomalies, and
- other anomalies.
Time-series anomalies:
- calendar anomalies,
- momentum and overreaction anomalies.
One category of time-series anomalies includes calendar anomalies.
The so-called January effect is (was) observed in many markets and may serve to us as the first example. It turns out that January is the month with significantly high returns. Because of the fact that this time is in no way connected with new market information, the market efficiency hypothesis is challenged.
How the January effect can be explained? For example, some investors sell unprofitable assets at the end of December to lower tax liabilities and repurchase them at the beginning of January. As the result, assets prices in January may increase.
Other examples of calendar anomalies are the turn-of-the-month effect, the day-of-the-week effect, the weekend effect, and the holiday effect.
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We distinguish between two types of cross-sectional anomalies:
- the size effect,
- the value effect.
The size effect is connected with small-cap companies yielding higher returns than large-cap companies. This type of anomaly was first spotted in the 80s and nowadays because investors know about this effect and want to exploit it by buying small-cap companies, achieving abnormal returns over long periods is no longer possible.
The value effect means achieving higher returns over a long period by companies that have (1) below-average price-to-earnings and price-to-book ratios and/or (2) above-average dividend yields as compared to growth companies.
Note that if investors can outperform the market in longer periods based on this anomaly, the semi-strong form of market efficiency will be challenged.
Examples of other anomalies:
- closed-end investment fund discounts,
- earnings surprise,
- initial public offerings (IPOs),
- predictability of returns based on prior information.
Shares of closed-end investment funds usually trade a few percentage points below NAV (net assets value) per share. We call this anomaly a closed-end investment fund discount. Potential explanations for this anomaly include management fee, management performance expectation, and no full control over the timing of gains or loss realization.
Earnings surprise means that the adjustment to positive and negative earnings surprises is not always efficient and quick.
Also, during initial public offerings, abnormal returns are very often earned and equity returns are correlated with past information (predictability of returns based on prior information), e.g. about interest rates, but it is almost impossible to earn abnormal returns even if you know about this correlation
Behavioral finance is a field of finance that studies the role of psychology in financial decision-making. It focuses on the so-called behavioral biases that impact investors’ decisions.
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- Market pricing anomaly is a situation in which changes in the price of financial instruments may not be explained by information currently available about these instruments.
- There are time-series anomalies, cross-sectional anomalies, and other anomalies.
- Time-series anomalies include calendar anomalies and momentum and overreaction anomalies.
- Cross-sectional anomalies include the size effect and the value effect.
- The size effect is connected with small-cap companies yielding higher returns than large-cap companies.
- The value effect means achieving higher returns over a long period by companies that have (1) below-average price-to-earnings and price-to-book ratios and/or (2) above-average dividend yields as compared to growth companies.
- Examples of other anomalies: closed-end investment fund discounts, earnings surprise, initial public offerings (IPOs), and predictability of returns based on prior information.
- Behavioral finance is a field of finance that studies the role of psychology in financial decision-making.