Fmi Lecture 7 Emh

FUNDAMENTALS OF FINANCE
Topic 8: Capital market efficiency
Faculty of Business, Economics and Law

Capital Market Efficiency
References
Prescribed reading
Frino Chapter 10
Chapter 16 (excluding Sections 16.6 and 16.7,

Peirson
although these are recommended reading)
Chapters 4 Pages 79 – 86
Bishop
Chapter 7 pages 169 – 181
These slides have been drafted by the La Trobe University Department of Finance based on Frino (2009). 8.2
Topic Overview
8.1 Introduction to capital market efficiency

8.2 Market efficiency theory
8.3 Tests of the Efficient Markets Hypothesis
8.4 Capital market anomalies
8.5 Possible explanations for anomalies
 Market efficiency specifically relates to

informational efficiency, and is concerned with
how rapidly security prices reflect or impound new
information that arrives to the market
 It is important to realise that this topic deals with a
‘theory’ – the theory of market efficiency
 However, a valid theory is supported by tests
against the ‘real world’, and we will also discuss
tests of the theory using data from the ASX
 In this lecture we will:

 Begin by outlining the theory itself
 Define the term “market efficiency”
 Explain how markets are kept efficient
 Discuss different possible levels of market
efficiency
 Examine tests of the efficiency of the ASX
 Consider capital market anomalies, and discuss
whether these represent evidence against the
Efficient Markets Hypothesis
 We will begin by describing two common

investment strategies that rely on there being a
difference between the market price of a security
and its “intrinsic” value – technical analysis and
fundamental analysis
 We will then go on to describe the Efficient
Markets Hypothesis and discuss the ways in
which it has been tested
8.1 Technical analysis
 Technical analysis relies on an analysis of past

prices to predict future price movements
 A technical analyst, or chartist, typically examines
charts of past prices in an attempt to identify
patterns or trends that might indicate how the
price will change in the future
 Historic information regarding the volume of
shares traded is also used
 Technical analysts believe that:

 Prices behave in a predictable way, and that
repeatable patterns can be used to predict future
prices
 Prices respond to the forces of supply and
demand, which in turn are driven by the
expectations and emotions of market participants
 They use past prices to learn about those
expectations and emotions
 A true technical analyst will disregard

“fundamental information” such as financial
statements and earnings forecasts
 He believes that it is not intrinsic value that drives
security prices, so much as investor expectations
and beliefs about intrinsic value
 He believes that this can be inferred from the
pattern of past prices
8.1 Fundamental analysis
 A fundamental analyst analyses publicly

available information in an attempt to determine
the intrinsic value of a security
 This typically involves similar techniques to
those covered in Topic 4
 The intrinsic value is then compared with the
market price in an attempt to identify
mispricing – overpriced or underpriced
securities
 If a fundamental analyst finds that the market

price is less than the intrinsic value, he will
conclude that the security is underpriced and
will buy it
 If the market price is greater than the intrinsic
value, he will conclude that the security is
overpriced, and sell
 If the market value equals the intrinsic value, he
will concluded that the security is fairly priced
 Fundamental analysts assume that:

 Publicly available information allows the intrinsic
value of an security to be determined
 The market is imperfect and mispricing occurs
 Market participants will eventually realise that the
security is mispriced
 In the future, prices will adjust to reflect the
intrinsic value, resulting in an abnormal profit for
the analyst
8.2 Market efficiency theory

 A famous paper by Professor Eugene Fama from
the University of Chicago defines market
efficiency as follows:
“THE SIMPLE STATEMENT THAT SECURITY PRICES
FULLY REFLECT ALL AVAILABLE INFORMATION”
 Fama is always careful to frame his ideas in
terms of a ‘hypothesis’, defined as:
“A PROVISIONAL SUPPOSITION FROM WHICH TO DRAW
CONCLUSIONS THAT SERVE AS A STARTING POINT
FOR FURTHER INVESTIGATION BY WHICH IT MAY BE
PROVED OR DISPROVED”
8.2 Definition of an efficient market
 A capital market is said to be informationally

efficient if prices fully reflect all available
information
 A market is efficient if security prices:
 Are unbiased (i.e. on average their price
equals their value)
 React immediately to the release of new
information
 Do not over-react or under-react
8.2 Implication of market efficiency
 If a market is efficient, it is impossible to

consistently identify mispriced securities and
trade in those securities to earn an abnormal
profit
 It may be possible to earn an abnormal profit
from time to time through sheer luck, but this
cannot be done consistently
 Investors would expect to earn a normal
profit – based on increases in intrinsic value
8.2 What keeps security prices efficient?
 The figure on the next slide demonstrates the

importance of information in securities markets
 At around 1.05pm on 30 August 2005 Tabcorp
Holdings released a preliminary final report
 This information was used by investors to revise
(upward) their view of the fair value of Tabcorp
 The price of Tabcorp shares rose from:
 $16.29 at 1.00pm to
 $16.64 at 1.30pm

16.80 4445.0
16.70 4440.0
4435.0
16.60
4430.0
16.50
4425.0
Index value
Price ($)
16.40 4420.0
16.30 4415.0
4410.0
16.20
4405.0
16.10
4000.0
TAH ASX200
16.00 4395.0
15.90 4390.0
10.10
10.00
10.30
12.50
13.40
14.20
14.00
14.50
15.20
15.30
16.00
13.00
10.20
10.40
10.50
11.40
11.50
12.00
13.10
13.20
13.50
15.00
15.10
11.00
11.30
14.40
15.40
16.10
15.50
11.10
11.20
12.20
12.30
12.40
13.30
14.10
14.30
12.10
Time
The price of Tabcorp against the ASX200 on 30/8/95

 If all market players had accurately predicted the

content of the earnings release prior to 1.05pm:
 There would have been large buying pressure in
Tabcorp, pushing the price up before the release
 When the earnings report was made public the
share price would not have changed
 Any attempt to trade on the information would
have netted no profit, because the share price
would already have reflected, or ‘impounded’, the
content of the information release
 Security analysts analyse information and

forecast the future cash flows of stocks
 As a result of trading by analysts’ clients on the
basis of the information and analysis provided:
 The first clients to trade make a profit
 The trading process causes security prices to
reflect the information uncovered by analysts
 Hence, it is the activities of security analysts and
their clients that cause prices to be efficient
 This gives rise to the efficient markets

paradox
 Investors will only analyse information, and
make buying and selling decisions based on
that information, if they believe that there is
mispricing of securities
 Therefore a market can only be efficient if there
enough participants who believe that it is
inefficient
8.2 Levels of market efficiency
 Fama identified three broad levels of market

efficiency, on the basis of the type of information
(“information set”) that is impounded in prices:
Level of efficiency Information Set
Weak-form Past prices
Semi-strong-form Public information
Strong-form All information

Weak-form Definition
Prices reflect all
Semi-strong-form information contained
in the record of past
Strong-form prices
Implications
(a) It is impossible to consistently make an abnormal
return by analysing past prices in an attempt to predict
future price movements
(b) Technical analysis will not result in an abnormal return
Prices fully reflect
Semi-strong-form all publicly
available
Strong-form information
Implications
(a) A semi-strong-form efficient market must also be weak-
form efficient because historic prices are publicly available
information
(b) It is impossible to consistently make an abnormal return by
analysing public information in an attempt to identify
mispriced securities
(c) Prices react immediately to the release of new information
Prices fully reflect
Semi-strong-form all publicly
available
Strong-form information
Implications (cont)
(d) “Immediately” means that investors do not have time
to profit from the release of new information
(e) Prices will not consistently over-react or under-react
to the release of new information
(f) Fundamental analysis will not result in an abnormal
return
All available
Semi-strong-form information is fully
reflected in current
Strong-form prices
Implications
A strong-form efficient market:
(a) Must also be semi-strong-form efficient (and therefore
weak-form efficient) because publicly available
information forms part of “all available information”
(b) Prices should reflect private information, or
information known only to a group of participants
(c) Insider trading will not result in an abnormal return
8.2 Private information
 A good example of private information is inside

information – information known only to “insiders”
in a privileged position in relation to a company
 Such information could, in theory, be reflected in
prices if insiders trade on information and are
able to move prices, revealing the information
 Insider trading is illegal in Australia and in most
developed countries, but that doesn’t necessarily
mean it doesn’t occur
8.3 Tests of the Efficient Markets Hypothesis
 A variety of tests can be conducted to try to

determine whether a market is efficient
 We will look at the following tests of capital
market efficiency:
 Do prices follow a “random walk”?
 Are trading rules profitable?
 Do prices react rapidly to information from
earnings announcements or large trades?
 Is it possible to profit from insider trading?
8.3 Tests of weak-form efficiency
 If a market is weak-form efficient, price

movements should be random and should not
exhibit trends
 There are at least two possible implications of this
prediction:
 Prices should follow a “random walk”
 Trading rules based on detecting and trading on
price patterns should be unprofitable
8.3 Do prices follow a “random walk”?
 Prices follow a random walk if the current price

(Pt) is unrelated to the previous price (Pt-1), or if
the value linking the two (e.g. ε) is a random
number, as follows:
Pt  Pt 1   (10.1)
 A chart showing the level of the ASX200 index

from Jul 2002 to Sep 2005 seems to show
periods when there are broad trends in prices

A B
4700
4500
4300
4100
3900
Index value
3700
3500
3300
3100
2800
2700
2500
Sep 02
Jan 03
May 03
Sep 03
Jan 04
May 04
Sep 04
Jan 05
May 05
Sep 05
Jul 02
Nov 02
Mar 03
Jul 03
Nov 03
Mar 04
Jul 04
Nov 04
Mar 05
Jul 05
Over shorter time frames, upward movements seem to follow previous
upward movements (area A) and downward movements seem to follow
previous downward movements (area B)
 The implication of these perceived patterns is that

there should be a very strong positive relationship
between price movements on consecutive days
 The next graph shows the relationship between
one day’s price movement and the previous day’s
 There is little evidence of a positive relationship –
it suggests that movements on consecutive days
are random, which is consistent with weak-form
efficiency

0.02
0.015
0.01
0.015
Yesterday’s return
-0.005
-0.01
-0.015
-0.02
-0.02 -0.015 -0.01 -0.005 0 0.005 0.01 0.015 0.02

Today’s return
Positive and negative relationships between returns on

consecutive days appear equally likely
8.3 Are mechanical trading rules profitable?
 The second testable implication of weak-form

efficiency is that it should not be possible to make
systematic profits from trading rules set up to
detect and trade on the basis of price trends
 An example of such a trading rule is a filter rule,
where the “filter” represents a set percentage by
which a stock must rise or fall in order to trigger a
“buy” or “sell” signal respectively
 For example, for a 10% filter rule, the investor

should:
 Buy if the stock rises 10% from its previous
lowest price
 Sell if the stock falls 10% from its previous
highest price
 If a sell signal precedes the first buy signal, the
investor would short-sell and then buy the stock
back upon the next buy signal

20.00
Dec 1969 – Buy BHP
19.00 back for $17.00
First falls by at
18.00 least 10%
17.00
First rises by
16.00
at least 10%
Price ($)
15.00
14.00
13.00
Feb 1969 – Sell
12.00 BHP for $17.40
11.00
10.00
Application of a 10% filter rule to BHP shares between

9
0
M 9
M 0
9
69
70
Se 9
0
69
-6
-7
-6
-7
-6
l-6
l-7
January 1969 and July 1970
n-
n-
p-
ay
ay
ar
ar
ov
Ju
Ju
Ja
Ja
M
M
N
 The assumption behind a filter rule is that the

trend identified by the rule will continue; future
price movements can be inferred from past prices
 One of the ways to test a filter rule is to apply the
buy and sell signals from one stock to a different
(or paired) stock
 If there is as much profit on the paired stock as
the original stock, any profits must be through
sheer luck, rather than a successful strategy

18.00
17.00 Feb 1969 – Also Sell

WMC for $11.70
16.00
15.00
14.00
Price ($)
13.00
12.00
11.00
10.00
Dec 1969 – Also Buy
9.00 WMC back for $16.80
8.00
Testing a filter rule by applying ‘buy’ and ‘sell’ signals from

9
0
M 9
M 0
9
69
70
Se 9
0
69
-6
-7
-6
-7
-6
l-6
l-7
BHP to WMC shares
n-
n-
p-
ay
ay
ar
ar
ov
Ju
Ju
Ja
Ja
M
M
N
8.3 Is the ASX weak-form efficient?
 A study by Ball (1978) using ASX data found that

‘the differences between returns on the filter
securities and the paired securities is quite small’
 Ball concluded that it is not possible to make
profits from trading rules relying on price patterns,
implying that the ASX is weak-form efficient
 More recent studies in other markets have
unanimously reported that no useful information
can be obtained from past prices
8.3 Is the ASX semi-strong-form efficient?
 In a semi-strong-form efficient market, prices

impound all publicly available information, and
therefore should adjust immediately after
information announcements
 The most common test of semi-strong-form
efficiency is an ‘event study’, which examines the
behaviour of prices around information ‘events’
 The purpose of the study is to analyse how
quickly new information is reflected in prices
 Since stock-price movements may be caused by

broad market movements as well as information
conveyed by an event, we need to isolate
abnormal returns (ARt), as follows:
ARt  Rt  E Rt  (10.2)
where:
Rt = the actual return
E(Rt) = the expected return in the interval t
 It is normal to use the CAPM to estimate
expected returns
8.3 Do stock prices react rapidly to information?
 A study by Aitken, Brown, Frino and Walter

(1995) looked at 30-minute abnormal stock price
returns around earnings announcements
 The study analysed announcements by 156
companies on the ASX during the year ended 30
June 1992
 The sample was divided into:
 Large stocks and small stocks
 Good news and bad news announcements

0.025
0.02
Mean abnormal return (%)
0.015
0.01
0.005
-0.005
-23
-20
-17
-14
-11
-8
-5
-2
11
14
17
20
23
Trading interval relative to announcem ent (half-hourly intervals)
Large stocks announcing good news show a sharp abnormal

price movement within 30 mins of the announcement

0.004
0.002
0
-0.002
-0.004
-0.006
-0.008
-0.01
-0.012
-0.014
-0.016
-23
-20
-17
-14
-11
-8
-5
-2
11
14
17
20
23
Large stocks announcing bad news also show a sharp

movement within 30 mins but not in any other interval

0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-23
-20
-17
-14
-11
-8
-5
-2
11
14
17
20
23
Small stocks announcing bad news show similar results to

large stocks – an immediate sharp movement in price

0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
-0.01
-23
-20
-17
-14
-11
-8
-5
-2
11
14
17
20
23
Small stocks with good news, however, show a large spike

about 6 hours later, suggesting less semi-strong efficiency
 Another test of semi-strong-form efficiency is to

analyse how quickly prices adjust to information
conveyed by large trades, or ‘block trades’
 The assumption is that large traders, such as
fund managers, are better informed than small
traders
 Hence, a large buy order might indicate to the
market generally that a stock is underpriced, and
a large sell order might indicate overpricing

0.2
0.15
0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25 Block purchases Block sales
-0.3
-5 -4 -3 -2 -1 0 1 2 3 4 5
Transaction relative to block trade
The chart indicates that there are large upward and downward
movements following block buy and sell orders respectively
 There is some evidence to suggest that the ASX

is semi-strong-form efficient:
 In most cases, the information contained in
earnings announcements is reflected in share
prices within 30 minutes
 One possible exception is good news from small
companies – it takes more time for this information
to be reflected in prices
 It takes no more than 3 trades for the information
conveyed by large trades to be impounded
8.3 Is the ASX strong-form efficient?
 If a market is strong-form efficient, it should not

be possible to profit from “insider trading”
 Hence, we may be able to infer strong-form
inefficiency from the fact that:
 Insider trading is illegal in Australia
 There have been a number of convictions for
insider trading
 Those convicted have profited from their illegal
activity
 If the ASX is strong-form efficient:

 Private information used for insider trading would
already be reflected in share prices
 It would not be possible to profit by trading on this
information
 It has been suggested that professional fund
managers have access to better (or private)
information, and may be able to profit by trading
on this information before it becomes public
 A study by Sawicki (2000) found that, after

adjusting for broad market movements, there is
little evidence that fund managers are able to
generate abnormal returns
 This result can be interpreted in 2 ways:
 Despite instances of insider trading, the market is
generally strong-form efficient, or
 Fund managers do not have access to private
information, or are unable to act upon it sufficiently
quickly to profit from it
 A capital market anomaly is a persistent

phenomenon where there appear to be abnormal
returns that cannot be explained by the EMH/
CAPM framework – they appear to indicate
market inefficiency
 Usually there is some variable that is associated
with abnormal returns, and therefore a trading
strategy could be formulated based on that
variable
 In this section we will examine a few of the more

well-known capital market anomalies
 Most of the evidence for these anomalies cited in
the textbook is from the USA and Australia,
although they have been documented across a
wide range of markets and countries
 We will conclude with an examination of possible
explanations for anomalies
8.4 The size effect (or small firm effect)
 Considerable evidence from the US and Australia

indicates that small firms persistently (and
significantly) outperform larger firms
 The effect is strongest for the smallest firms and
disappears quickly with increasing firm size
 The size effect appears to be even more
pronounced in Australia than in the US
8.4 Monthly seasonality

 Average returns are observed to be higher in
some months than others
 Average returns in the US are higher in January
than any other month, and for this reason this
anomaly is often referred to as the January
effect
 This effect is more pronounced in small firms (the
January size effect)
 In Australia there appears to be both a January
effect and a July effect
8.4 Book-to-market effect
 The book-to-market ratio is the ratio of the book

value of a firm to the value of the firm measured
by share price
 High book-to-market firms are often referred to a
“value” stocks and low book-to-market firms are
referred to as “growth” stocks
 It has been shown that value stocks consistently
(and significantly) outperform growth stocks
8.4 Day-of-the-week effect
 In the US average returns are significantly lower

on Monday than any other day of the week, and
this effect is often referred to as the Monday
effect
 In Australia average returns are negative on
Monday but are lowest and consistently negative
on Tuesday
 Both the Monday and Tuesday effects seem to be
weakening in recent years
8.4 Price-earnings effect
 This anomaly is based on a firm’s price to

earnings ratio (P/E ratio)
 It has been found in the US that stocks with the
lowest P/E ratios outperform those with the
highest P/E ratios
 The evidence in Australia is strikingly different – it
has been found that stocks with the highest P/E
ratio outperform those with the lowest
8.5 Possible explanations for anomalies
 Various explanations have been proposed for

capital market anomalies. It may be that the
there is no single correct explanation, but rather a
combination of the following:
 Market inefficiency
 Economic explanations
 Systematic experimental error
8.5 Market inefficiency
 The most obvious explanation for capital market

anomalies is that the market really is inefficient,
and in some cases this may be the case
 However, many are of the view that the
persistence of these anomalies is evidence they
don’t prove inefficiency
 We would expect investors to develop trading
strategies to take advantage of (and hence
eliminate) the anomaly
8.5 Economic explanations
 A variety of economic explanations for capital

market anomalies have been offered
 We will briefly consider three of the main
explanations (although many others have also
been put forward):
 The tax-loss-selling hypothesis
 Asset pricing model misspecification
 Firm size as a proxy variable
8.5 The tax-loss-selling hypothesis
 Monthly seasonality (e.g. the January effect) has

often been linked to the tax-loss-selling
hypothesis
 This states that investors are more likely to sell
shares on which they have an unrealised loss in
the last month of the tax year in order to
crystallise the loss and claim it as a tax
deduction
 Investors will then take advantage of low prices

and repurchase stocks after the end of the tax
year, causing higher prices and positive
abnormal returns
 This might explain the January effect in the US
(where December is the end of the tax year), the
July effect in Australia (where June is the end
of the tax year) and the April effect in the UK
(where the tax year ends in March)
 It is less obvious why there should also be a

January effect in Australia
 The general consensus is that the US market
has significant influence over the Australian
market, and falling prices in December in the US
market are reflected in depressed prices in
Australia
8.5 Asset pricing model misspecification
 It has also been suggested that these apparent

anomalies are caused by misspecification of
the asset pricing model used to estimate
normal returns
 In other words, there are systematic risk factors
that determine the level of return that are not
being captured by the asset pricing model used
– almost always the CAPM
8.5 Asset pricing model misspecification
 Most research in this area has attempted to use

Arbitrage Pricing Theory to better explain returns
and therefore eliminate the anomalies
 A five-factor APT has been found to explain
some of these anomalies (e.g. the January size
effect), while a three-factor model explains other
anomalies
 Overall, evidence for this explanation is
inconclusive
8.5 Firm size as a proxy variable
 Some have argued that the size of a firm is a

proxy for other risk factors that drive returns but
are not explicitly captured by the asset pricing
model
 For example, shares in small firms might trade in
less liquid markets, have less information
available and have higher transactions costs
 Investors will therefore demand a premium to
invest in these stocks
8.5 Systematic experimental error
 A third explanation says that the market is

efficient, the pricing model is not misspecified,
but there are experimental errors in the research
that has unearthed the apparent anomalies
 These errors usually relate to the measurement
of returns or the estimate of beta used in the
pricing model
8.5 The Efficient Markets Hypothesis – a final word
 Market efficiency is one of the most intensively

researched areas in finance, but the results are
still not completely conclusive
 Where evidence of market inefficiency appears
to exist, it is usually the case that transaction
costs outweigh any potential benefits
 The general conclusion is that markets are
generally semi-strong-form efficient, but do not
appear to be strong-from efficient

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FUNDAMENTALS OF FINANCE

Topic 8: Capital market efficiency

Faculty of Business, Economics and Law

Chapter 16 (excluding Sections 16.6 and 16.7,

8.1 Introduction to capital market efficiency

8.1 Introduction to capital market efficiency

 Market efficiency specifically relates to

8.1 Introduction to capital market efficiency

 In this lecture we will:

8.1 Introduction to capital market efficiency

 We will begin by describing two common

8.1 Technical analysis

 Technical analysis relies on an analysis of past

8.1 Technical analysis

 Technical analysts believe that:

8.1 Technical analysis

 A true technical analyst will disregard

8.1 Fundamental analysis

 A fundamental analyst analyses publicly

8.1 Fundamental analysis

 If a fundamental analyst finds that the market

8.1 Fundamental analysis

 Fundamental analysts assume that:

8.2 Market efficiency theory

8.2 Definition of an efficient market

 A capital market is said to be informationally

8.2 Implication of market efficiency

 If a market is efficient, it is impossible to

8.2 What keeps security prices efficient?

 The figure on the next slide demonstrates the

8.2 What keeps security prices efficient?

The price of Tabcorp against the ASX200 on 30/8/95

8.2 What keeps security prices efficient?

 If all market players had accurately predicted the

8.2 What keeps security prices efficient?

 Security analysts analyse information and

8.2 What keeps security prices efficient?

 This gives rise to the efficient markets

8.2 Levels of market efficiency

 Fama identified three broad levels of market

Weak-form Past prices

Semi-strong-form Public information

Strong-form All information

8.2 Levels of market efficiency

8.2 Levels of market efficiency

8.2 Levels of market efficiency

8.2 Levels of market efficiency

8.2 Private information

 A good example of private information is inside

8.3 Tests of the Efficient Markets Hypothesis

 A variety of tests can be conducted to try to

8.3 Tests of weak-form efficiency

 If a market is weak-form efficient, price

8.3 Do prices follow a “random walk”?

 Prices follow a random walk if the current price

 A chart showing the level of the ASX200 index

8.3 Do prices follow a “random walk”?

8.3 Do prices follow a “random walk”?

 The implication of these perceived patterns is that

8.3 Do prices follow a “random walk”?

-0.02 -0.015 -0.01 -0.005 0 0.005 0.01 0.015 0.02

Positive and negative relationships between returns on

8.3 Are mechanical trading rules profitable?