COMM 298

Topic 5 – Market Efficiency

(Synchronous)
Market Efficiency
 Objectives
By the end of this class, you should be able to:
• Distinguish between the three forms of the
Efficient Markets Hypothesis.
• Discuss the implications of each form.
• Review some of the evidence on market
efficiency.
• Determine when information will have an
impact upon prices in an efficient market.
 Efficient Markets Hypothesis

EMH: when forming their expectations

about future asset cash flows and risk,
investors use all available and relevant
information.

Result: Proper forecasting and pricing

occurs. “Prices are right.”
 Market Efficiency
• A market is efficient if prices quickly and
accurately reflect new information.

• There are three different forms of market

efficiency, distinguished by the type of
information that prices reflect.
 Market Efficiency
1. A market is weak form efficient if prices
reflect all information about past prices.

2. A market is semi-strong form efficient if

prices reflect all publicly available
information.

3. A market is strong form efficient if prices

reflect all information, public or private.
 Weak Form Efficiency
• In a market that is weak form efficient, prices
reflect all information about past price history.
• Technical analysis is a system for estimating
future prices based on past price patterns.
• Why is technical analysis pointless in a weak form
efficient market?
Prices already reflect all information about price history
so there can’t be any trading advantage in tracking it.
 Semi-Strong Form Efficiency
• If a market is semi-strong form efficient, prices
reflect all public information.
• Fundamental analysis uses publicly available
financial, accounting and economic information
to estimate “fundamental” values for securities.
• Why is fundamental analysis pointless in a
semi-strong form efficient market?
Once info becomes public, it is immediately reflected in
the asset price, so there’s no trading advantage.
 Strong Form Efficiency
• In a market that is strong form efficient, prices
instantly reflect all information, public or private.
• The illegal use of private information is what
gets people indicted for insider trading.
• In a strong form efficient market, why is there no
advantage to trading on private information?
If prices instantly reflect all information, you can’t earn
abnormal returns by trading on private information. All
secrets are already reflected in the asset’s price.
 Insider trading
• It is illegal to use private information to trade and make
profit.
• This private or “insider information” is material, non-
public, price sensitive information possessed by
corporate insiders such as company executives.
• It is expected that insider information would affect
share prices, if it was made public.
• In a strong form efficient market, there no advantage to
trading on insider information, because all public and
non-public information is already reflected in the stock
price.
Market Efficiency - summary
• It helps to think of the different forms of
market efficiency as meaning that prices
incorporate a steadily increasing set of
information and that each of these forms
encompasses all the lower forms.
• For example, since the history of past prices
is public information, semi-strong form
efficiency encompasses weak form efficiency.
• The information sets of each of the different
forms are illustrated in the following diagram.
Market Efficiency - summary
All information

Public Information

Past Price
Information
• If the market is strong form efficient, then it must
also be semi-strong form efficient and weak
form efficient. Reason?
If prices reflect all information, then they reflect
all public information and all past price
information.
• If the market is semi-strong form efficient, then it
must also be weak-form-efficient. Reason?
If prices reflect all public information, then they
reflect past price information.
• If the market is weak form efficient, then that is
all we know for sure.
• Beliefs among market participants about market
efficiency vary …
• Technical analysts, who look for patterns in past
stock prices, do not believe the market is even
weak-form efficient.
• Mutual fund managers and fundamental analysts
believe that mispricing can be uncovered by
careful analysis of company fundamentals.
• Insiders who trade on their inside information
about an upcoming merger or earnings
announcement do so because they believe they
will profit from this illegal activity.
 So How Efficient Are Markets, Really?
• The evidence is definitely mixed …

• Most evidence supports the idea that financial

markets are weak-form efficient. As such,
there is not much advantage to subscribing to
newsletters where experts come up with
investment advice based on reading charts.
• On the other hand, there is evidence that
markets are not strong form efficient.
There is value to trading on private
information; if there weren’t, people
wouldn’t do it, and we wouldn’t need laws
banning insider trading.
• The battleground is whether or not markets are
semi-strong form efficient.
– Most academics believe that markets are
semi-strong form efficient.
– Some investment managers believe that
markets aren’t semi strong form efficient.
• The truth with respect to the semi-strong form
probably lies somewhere in the middle. Markets
are generally efficient, but anomalies exist that
are evidence to the contrary (e.g. the January
effect).
• The following is likely to be true:
– Well-established, liquid markets for securities
whose properties are well understood will
tend to be semi-strong form efficient.
– Pockets of inefficiency may exist in newly-
established, illiquid markets for new types of
securities that are not yet well understood.
 When Should Prices Adjust to New
Information?
• Suppose price of a security = $20
New information arrives to the market.
Market consensus is that new price will be $25.

• When will the market price move to $25?

• Will the price move gradually up to $25?

 Market Efficiency Problem

Suppose today is March 1. Western Mining opened

trading this morning at a price of $40 per share. This
afternoon, Cabot Enterprises decides that it will take
over Western by paying Western’s shareholders $50
per share when the deal is finalized. Due to legal
problems, the firms can’t announce the deal to the
public until April 1 (it is “inside information” only on
March 1). The deal will be finalized on May 1 and
the $50 will be paid on that date. The expected return
for Western Mining common share is 1% per month.
What would we expect Western’s stock price would
be at the close of trading on each of the dates below?

Semi-Strong Form Strong Form

Market Efficiency Market Efficiency
Holds Holds
March 1 $40 $50/(1.01)2=$49.01

April 1 $50/1.01=$49.50 $50/1.01=$49.50

May 1 $50 $50

Efficiency, Overreaction, Underreaction
Consider a firm whose dividend is $10/share in 2020. The
appropriate discount rate is 10%. Everyone expects that
the dividend growth rate will be either -5%, 0%, or 5%
with equal probability each year.

What is the expected growth rate, and the 2020 price per
share of the firm, assuming no growth beyond the current
year?
• Expected dividend growth is (1/3)*(-5+0+5)=0%
• The price per share is 10/(0.1-0)=100
Efficiency, Overreaction, Underreaction
The growth from 2020 to 2021 turns out to be 5%. This
information is revealed in January 2021.
What is the price of the firm in January 2021?
• If the dividend rises from $10 by 5% to $10.5, then the
new price is $105
What is the 2021 expectation of the January 2022 price?
• In expectation dividend growth is 0%, therefore, the
expected dividend in 2022 is $10.5 and the expected price
is $105
Efficiency, Overreaction, Underreaction
Suppose that for some reason, the price in January 2021 is
only $103. By 2022 it reaches its expected price. This is
referred to as underreaction. The price does not adjust to
the full information price immediately.
Why might markets underreact?
Perhaps not all investors realize that the dividend has
grown. Some do and believe the firm’s price should rise by
a lot. Some do not, and believe the 2020 price is
appropriate. The actual price is the average of the two
types of investors.
Efficiency, Overreaction, Underreaction
Suppose that for some reason, the price in January
2021 is $107. By 2022 it reaches its expected price.
This is referred to as overreaction. The price
adjusts by too much and overshoots the full
information price
Why might markets overreact?
Perhaps investors get too enthusiastic about good
news, and think its much better than it actually is
Efficiency, Overreaction, Underreaction
In the above example growth turned out to be above
expectations. Over- and under- reaction can also
happen when growth turns out to be below
expectations. Suppose the growth from 2020 to 2021
turns out to be -5%. This information is revealed in
January 2021.
What is the price of the firm in January 2021?
What is the 2021 expectation of the January 2022
price?
Efficiency, Overreaction, Underreaction
What is the price of the firm in January 2021?
-If the dividend falls from $10 by 5% to $9.5, then
the new price is $95

What is the 2021 expectation of the January 2022

price?
-In expectation dividend growth is 0%, therefore,
the expected dividend in 2022 is $9.5 and the
expected price is $95
Efficiency, Overreaction, Underreaction
Suppose that for some reason, the price in January
2021 is only $97. By 2022 it reaches its expected
price. This is another underreaction. The price
does not adjust to the full information price
immediately. OR
Suppose that for some reason, the price in January
2021 is $93. By 2022 it reaches its expected price.
This is referred to as overreaction. The price
adjusts by too much and overshoots the full
information price.
Over- and Under- reaction
 Over- and Under- reaction
• If sometimes we see overreaction, and
sometimes we see underreaction, but on average
the market reacts appropriately, then the market
is still efficient
– Sometimes the market is wrong, but there is
no systematic bias
– Risk adjusted returns are unpredictable!
 Over- and Under- reaction
• However, if on average, we see a consistent
underreaction then the market is likely
inefficient
– How would you make money if you
know the market on average underreacts?
• If on average, we see a consistent
overreaction, then the market is also likely
inefficient
– How would you make money if you
know the market on average overreacts?