Securities Analysis and Portfolio

Management
(Course Code: MGT -631)

Assignment No. 02
Topic: Efficient Capital Markets

Submitted To: Mam Asima Saleem

Submitted By: M Talha Afzal

Reg #: 18-Arid-853
Semester- 6

Gujrat Institute of Management Sciences

PMAS-Arid Agriculture University Rawalpindi
What is efficiency, efficient capital markets, and efficient market hypothesis,
answer in context of article?

Efficiency
The term “efficiency” denotes the fact that investors have no opportunity of obtaining
abnormal profits from capital market transactions as compared to other investors, they cannot
beat the market. So, the only way an investor may obtain a larger profit is by investing in higher
risk assets.

Efficient Capital Markets

A market in which “prices fully reflect all known information, and even uninformed
investors buying a diversified portfolio at the tableau of prices given by the market will obtain a
rate of return as generous as that achieved by the experts”

Efficient Market Hypothesis

Efficient market hypothesis is very controversial and of particular interest for financial
economists. It states that prices reflect all available information. After many tries to find the truth
behind the EMH but no ultimate conclusion exists.

Differentiate between weak form, semi-strong form, and strong form EMH,
answer in context of article?

Weak Form EMH

The weak form of EMH was presented as the state of fact in which the current prices of
financial assets incorporate, at any moment, all the existing historical financial information. As a
result, the theory supports the idea that investors cannot obtain abnormal profits from investing
in these financial assets. This EMH form implies that prices will exhibit random walk.

Semi-Strong Form EMH

The semi-strong form assumes that financial assets’ prices reflect, at any moment, all the
information existent on a market, including historical prices and other historical information
(which means this form incorporates also the weak form of EMH), and, additionally, the prices
change rapidly and without biases to incorporate any other new public information released on
the market. In case semi-strong form of EMH is present on a capital market, neither technical nor

Page 1 of 6
fundamental analysis can determine the way an investor should split his funds so that the
obtained profitability is higher than that achieved in case of investment in a random portfolio of
financial assets.

Strong Form EMH

The strong form of EMH assumes that prices incorporate all the available information on
a market, which includes: historical financial information (weak form), all new public
information (semi-strong form) and all private information regarding a financial asset.

This study consisted of event study, highlight the event studied, time period,
and reason for study?

Event Studied
Most of the papers are based on event studies.

Some of them analyze the reaction on the first few days after distinct types of announcement, in
the idea of that price of financial assets quickly react to new information, so that the efficiency of
capital markets is confirmed.

Other category of studies have analyzed a longer time horizon, based on the fact that the prices
gradually adjust to new information released, thus invalidating the EMH on medium and long
term.

Time Period
This survey examines the growing body of empirical research on efficient market hypothesis.

Reference two example studies of EMH on short term and long term?

EMH on Short-term
1. Fama, Fisher, Jensen and Roll (1969) analyzed 940 split events between 1927 and 1959,
concluding that the largest positive abnormal returns are recorded in the first 3-4 months
after announcement, sustaining in this way the gradual adjustment of prices on capital
markets.

Page 2 of 6
 2. Another study from 1968, realized by Ball and Brown, showed that capital markets are
inefficient based on a sample of 2340 recordings from 1946-1966 regarding reaction to
accounting income announcements. Stock prices react slowly to new information and
they adjust during the first 12 months after the announcement – the EMH is invalidated.

EMH on Long-term
1. In 1985, DeBondt and Thaler published a paper that analyzed stock long term returns.
They concluded that companies with 3-5 years of positive returns continue to obtain
negative returns. The vice-versa also holds. This study is based on the idea that investors
tend to invest as a result of an increase in stocks’ returns during a specific period of time
without taking into account the general characteristic of all stocks, that they are mean
reverting. So, weak EMH is invalidated.
2. Few years later, in 1994, Lakonishok et al. concluded that companies with high values of
E/P (earnings/price), CF/P (cash flow/price) and BE/ME (book–to–market equity) tend to
have poor historical evolution of stock prices. On the other way around, companies with
small values of these indicators appear to have a historical rising average return. As a
result, the future performance of the companies included in the first category is expected
to be better than that expected for the second category of companies, so that the semi
strong form of EMH does not hold.

Briefly discuss the market anomalies.

Market Anomalies
A market anomaly is a price action that contradicts the expected behavior of the stock
market. Some financial anomalies appear only once and disappear, but others appear consistently
throughout historical chart analysis. Traders and investors can use these unusual market
behaviors to find opportunities throughout the stock market.

A market anomaly refers to the difference in a stock’s performance from its assumed
price trajectory, as set out by the efficient market hypothesis (EMH). The appearance of financial
market anomalies provides evidence that the EMH doesn’t always hold true, as not all relevant
information is priced in straight away or at all.

We take a look at some of the most common anomalies, how behavioral finance theory
explains their reoccurrence and the ways traders can take advantage of the unusual market.

Page 3 of 6
Calendar Effects
Anomalies that are linked to a particular time are called calendar effects. Some of the most
popular calendar effects include:

Weekend Effect: The weekend effect describes the tendency of stock prices to decrease on
Mondays, meaning that closing prices on Monday are lower than closing prices on the previous
Friday. From 1950 through 2010, returns on Mondays for the S&P 500 were consistently lower
than every other day of the week. In fact, Monday was the only weekday with a negative average
rate of return.

Turn-of-the-Month Effect: The turn-of-the-month effect refers to the tendency of stock prices
to rise on the last trading day of the month and the first three trading days of the next month.

Turn-of-the-Year Effect: The turn-of-the-year effect describes a pattern of increased trading

volume and higher stock prices in the last week of December and the first two weeks of January.

January Effect: Amid the turn-of-the-year market optimism, there is one class of securities that
consistently outperforms the rest. Small-company stocks outperform the market and other asset
classes during the first two to three weeks of January. This phenomenon is referred to as the
January effect. Occasionally, the turn-of-the-year effect and the January effect may be addressed
as the same trend, because much of the January effect can be attributed to the returns of small-
company stocks.

September Effect: The September effect refers to historically weak stock market returns for the
month of September. There is a statistical case for the September effect depending on the period
analyzed, but much of the theory is anecdotal. It is generally believed that investors return from
summer vacation in September ready to lock in gains as well as tax losses before the end of the
year. There is also a belief that individual investors liquidate stocks going into September to
offset schooling costs for children. As with many other calendar effects, the September effect is
considered a historical quirk in the data rather than an effect with any causal relationship.

Page 4 of 6