Chapter 1
Conceptual Foundations of Capital Market Anomalies
This book describes unexpected price behavior in equity markets, termed Anomalies, that can potentially be exploited by investors to earn abnormal returns. In capital markets, an anomaly is a deviation from the prediction of the efficient markets theory. The purpose of this chapter is to provide a conceptual framework for understanding the academic research on anomalies and to evaluate whether certain anomalies can be profitably exploited. The chapter begins with a discussion of efficient markets theory, which specifies how assets (specifically stocks) are expected to be priced under a set of ideal or theoretical conditions. The discussion then moves on to anomalies, or price behavior, that is unexpected if markets are efficient. The chapter defines anomalies, discusses explanations for anomalies that have been examined in the academic literature, and concludes by weighing the evidence for these different explanations. Since anomalies yield predictable positive risk-adjusted returns, proper risk measurement is critical to the identification of anomalies. Hence, the appendix to this chapter provides a detailed review of risk measurement and expected return models.1
No specific anomaly is discussed in this chapter, because the discussion here is intended to be applicable to all anomalies. It is hoped that, at the end of this chapter, investors will have the conceptual tools necessary to evaluate and understand ...
