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Market Efficiency PDF
Market Efficiency PDF
Market Efficiency PDF
1
Market Efficiency
An informationally efficient market is one where
security prices adjust rapidly to reflect any new
information.
• In an efficient market, it is difficult to find inaccurately
priced securities. Therefore,
• superior risk-adjusted returns cannot be attained.
• pursue a passive investment strategy, which
entails lower costs.
• In an inefficient market, securities may be mispriced.
Therefore,
• trading in these securities can offer positive risk-
adjusted returns.
• pursue an active investment strategy.
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Market Value vs. Intrinsic Value
Market value
• Price at which the asset can currently be bought or
sold.
• It is determined by the interaction of demand and
supply for the security in the market.
Intrinsic value
• Value of an asset that reflects all its investment
characteristics accurately.
• They are estimated in light of all the available
information regarding the asset; they are not known
for certain.
If markets are not efficient, investors may try to
develop their own estimates of intrinsic value in
order to profit from any mispricing (difference
between the market price and intrinsic value).
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Factors Affecting a Market’s Efficiency
• Market participants
• Limits to trading
4
Weak-Form Efficient Market
Hypothesis
Weak-form EMH assumes that current stock prices
reflect all security market information including
historical trends in prices, returns, volumes, and
other market-generated information such as block
trades and trading by specialists.
Future returns on a stock should be independent of
past returns or patterns.
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Implications of Efficient Market Hypothesis
Securities markets are weak-form efficient.
• Therefore, past trends in prices cannot be
used to earn superior risk-adjusted returns.
Securities markets are also semi-strong-form
efficient.
• Therefore, investors who analyze
information should consider what
information is already factored into a
security’s price, and how any new
information may affect its value.
Securities markets are not strong-form
efficient.
• This is because insider trading is illegal. 9
Implications of Efficient Market Hypothesis
Efficient Markets and Technical Analysis
• If the market is weak-form efficient, technical trading systems that depend
only on past trading and price data cannot hold much value.
Efficient Markets and Fundamental Analysis
• Fundamental analysis is necessary in a well-functioning securities market,
as it helps market participants understand the implications of any new
information.
• Fundamental analysis can help generate abnormal risk-adjusted returns if
an analyst is superior to her peers in valuing securities.
Efficient Markets and Portfolio Management
• If markets are weak-form and semi-strong-form efficient, active
management is not likely to earn superior risk-adjusted returns on a
consistent basis. Therefore, passive portfolio management would
outperform active management.
• The implication here is that the role of the portfolio manager is not
necessarily to beat the market, but to manage the portfolio in light of the
investor’s risk and return objectives.
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Market Pricing Anomalies
An anomaly occurs when a change in the price of an
asset cannot be explained by the release of new
information into the market.
• If markets are efficient, trading strategies designed to
exploit market anomalies will not generate superior
risk-adjusted returns on a consistent basis.
• An exception to the notion of market efficiency (an
anomaly) would occur if a mispricing can be used to
earn superior risk-adjusted returns consistently.
Observed anomalies can be placed into three
categories:
1. Time-series anomalies
2. Cross-sectional anomalies
3. Other anomalies
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1. Time-Series Anomalies
Calendar Anomalies:
• January effect
• Turn-of-the-month effect
• Day-of-the-week effect
• Weekend effect
• Holiday effect
Momentum Anomalies:
Securities that have outperformed in the short term
continue to generate high returns in subsequent
periods (carrying on price momentum).
Overreaction Anomalies:
Investors tend to inflate (depress) stock prices of
companies that have released good (bad) news.
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2. Cross-Sectional Anomalies
Size effect:
Shares of smaller companies outperformed
shares of larger companies on a risk-
adjusted basis.
Value effect:
Low-P/E stocks have experienced higher
risk-adjusted returns than high-P/E stocks.
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3. Other Anomalies
Closed-end investment fund discounts:
Closed-end funds tend to trade at a discount (sometimes
exceeding 50%) to their per-share NAVs.
Earnings surprises:
Although earnings surprises are quickly reflected in
stock prices most of the time, this is not always the case.
Initial public offerings (IPOs):
Investors who are able to acquire the shares of a
company in an IPO at the offer price may be able to earn
abnormal profits.
Predictability of returns based on prior information:
Equity returns are based on factors such as interest
rates, inflation rates, stock volatility, etc.
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Implications for Investment Strategies
Although there is some evidence to support
the existence of valid anomalies, it is difficult
to consistently earn abnormal returns by
trading on them.
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Behavioral Finance
Behavioral finance is a field of study that
examines investor behavior and evaluates
the impact of investor behavior on financial
markets.