Efficient Market

Theory
Compiled by: CA Sapna Jain

4/20/15

The efficient market hypothesis

is a central idea of a modern
finance that has profound
implications. An understanding
of the efficient market
hypothesis will help to ask the
right questions and save from
a lot of confusion that
dominates popular thinking in
finance.

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Definitions
Market Efficiency: The expectations of the investors regarding
the future cash flows are translated or reflected on the share
prices. The accuracy and the quickness in which the market
translates the expectation into prices are termed as market
efficiency. These are of two types:
(1) Operational Efficiency: It can be measured by factors like
time taken to execute an order and the number of bad
deliveries. Investor are concerned with this type of
efficiency but EMH does not.
(2) Informational Efficiency: It is a measure of the swiftness
or the markets reaction to new information like
economic reports, company analysis, political statements
& new industrial policies.
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Definitions
Liquidity Traders: These traders investments and resale
of shares depends upon their individual fortune. Liquidity
traders sell their shares to pay their bills. They dont
investigate before they invest.

Information Traders: These investors analyze before

any buy or sell. They estimate the intrinsic value of
shares. The deviation between the intrinsic value and
the market value makes them enter the market. They
sell if the market is higher than the intrinsic value and
vice-versa. The buying and selling of the shares through
the demand and supply forces bring the market price
back to its intrinsic value.
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Random-Walk Theory
An efficient market is one in which the market price
of a security is an unbiased estimate of its intrinsic
value.
Note: Market efficiency does not imply that the
market price equals intrinsic value at every point in
time. All that it says is that the errors in the market
prices are unbiased. This means that the price can
deviate from the intrinsic value but the deviations
are random and correlated with any observable
variable. If the deviations of market price from
intrinsic value are random, it is not possible to
consistently identify over or under-valued securities.
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No Bargain
Market efficiency is defined in relation to
information that is reflected in security prices.
In an efficient market, all the relevant
information is reflected in the current stock
price.
Information cannot be used to obtain excess
return. The information has already been
taken into account and absorbed in the prices.
In other words, all prices are correctly
stated and there are no bargains in the
stock market.
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Requirements for efficient

market
1. Prices must be efficient so that new inventions and better
products will cause a firms securities prices to rise and
motivate investors to supply capital to the firm (i.e., buy its
stock).
2. Information must be discussed freely and quickly across the
nations so all investors can react to new information.
3. Transactions costs such as sales commissions on securities
are ignored.
4. Taxes are assumed to have no noticeable effect on
investment policy.
5. Every investor is allowed to borrow or lend at the same rate.
6. Investors must be rational and able to recognize efficient
assets and that they will want to invest money where it is
needed most (i.e., in the assets with relatively high returns).
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Forms of EMH
Strongly efficient market
All information is reflected on
prices.
Semi Strong efficient market
All public information is
reflected on security
prices.
Weakly efficient
market All
historical
information is reflected on security prices.

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Weak Form of EMH

The week form of market holds that
present stock market prices reflect all
known information with respect to past
stock prices, trends, and volumes.
This form of theory is just the opposite of
the technical analysis because according to
it, the sequence of prices occurring
historically does not have any value for
predicting the future stocks prices. The
technical analysts rely completely on charts
and past behavior of prices of stocks.
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Weak Form of EMH

In the week form of the market no
investor can use any information of the
past to earn a return of portfolio which
is in excess of the portfolios risk.
This means that the investor who develops
the strategy based on past prices and
chooses his portfolio on that basis cannot
continuously outperform another investor
who buys and holds his investments over a
long term period.

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Weak Form of EMH

Weak form takes only the average change of todays
prices and states that they are independent of all prior
prices.
The evidence supporting the random walk behavior also
supports the EMH and states that the large price changes
are followed by larger price changes, but they do not
change in any direction which can be predicated. This
observation in a way violates the random walk behavior that
it does not violate the weak form of the market efficiency.
Researchers have studied that the evidence which supports
the efficient market behavior is based on the random
walk behavior of security prices but there is evidence
which contradicts the random walk hypothesis. This does not
mean that it contradicts the efficient market hypothesis also.
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Weak Form of EMH

Three types of tests have been
commonly employed to
empirically verify the weakform efficient market
hypothesis:
(a) Serial correlation tests;
(b) Runs tests
(c) Filter rules tests.

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Weak Form of EMH

Serial Correlation Test:

Serial Correlation is said to measure the association of

a series of numbers which are separated by some
constant time period. One way to test for randomness
in stock price changes is to look at their serial
correlations. Is the price change in one period
correlated with the price change in some other
period? If such auto-correlations are negligible, the
price changes are considered to be serially
independent. Numerous serial correlation studies,
employing different stocks, different time-lags, and
different time-periods, have been conducted to detect
serial correlations. In general, these studies have
failed to discover any significant serial correlations.
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Serial Correlation Test

Moore measured correlation of the price change of
one week with the price change of the next week. His
research showed average serial correlation of -0.06
which indicated a very low tendency of security price
to reverse dates. This means that a price rise did not
show the tendency to follow the price fall or vice
versa.
Fama also tested the serial correlation of daily price
changes in 1965. He studied the correlation for 30
firms which composed of the Dow Jones Industrial
Averages for five years before 1962. His study
showed an average correlation of -0.03. This
correlation was also weak because it was not very far
away from zero.
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Weak Form of EMH Run Test

Run Test was also made by Fama to find out it
price changes were likely to be followed by further
price changes of the same sign. Run Test ignored
the absolute values of numbers in the series and
took into the research only the positive and
negative signs. Given a series of stock price
changes, each price (+) if it represents an
increase or a minus (-) if it represents a decrease.
Run test is used to find out whether the series of
prices movement have occurred by chance. A run
is uninterrupted sequence of the same
observation.
cont..
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Weak Form of EMH Run Test

For Example: If a coin is tossed the following
sequence my occur:
HHTTTHHHTHH
Here occurrence of HH is a run and TT is another run.
When the sequence of the observations change we
count it as a run
Run Test Z = R X
R = No. of runs
X=
2n1 n2 + 1
n1 + n 2
2 =
2n1 n2 (2n1 n2 - n1 - n2 )
(n1 + n2 )2 (n1 + n2 - 1 )
n1 + n2 = No. of observations in each category
Z = standard normal variate
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Weak Form of EMH Run Test

Ques: Reliance Petroleum stock prices are
given below , apply run test.
Dat
e
Sept.
20
21
22
23
24
28
29
Oct. 1
4
5
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Pric Run
e
43.05
43.40
41.75
42.65
43.60
43.05
43.40
46.80
46.60
47.50
47.40

Dat
e
7
8
11
12
13
14
15
19
20
21
25
26

Pric Run
e

Dat
e

Pric Run
e

52.15
52.50
53.45
57.55
57.45
55.90
54.15
54.70
58.95
60.30
59.65
58.65

27
28
29
Nov.
1
2
3
4
5
7
9
10

56.80
53.50
51.50
48.40
52.30
56.05
55.15
56.40
57.15
57.25
57.55
56.75

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Weak Form of EMH Filter rule

It is a technique for filtering out the important
information from the unimportant. Alexander and
Fama and Blume took the idea that price and volume
data are supposed to tell the entire story we need to
know to identify the important action in stock prices.
They applied filter rules to see how well price
changes pick up both trends and reverses which
chartists claim their charts do.
If a stock moves up X%, buy it and hold it long; if it
then reverses itself by the same percentage, sell it
and take a short position in it. When the stock
reverses itself again by X% cover the short position
and buy the stock long. The size of the filter varied
from 0.5 to 50%.

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Weak Form of EMH Filter Rule

Example: Let filter in XY Ltd is 10%. The
Price fluctuate between Rs. 20 to 30. Let
starting point to be 20. When there is an
increase in the price to Rs. 22 i.e. 10%
rise, one has to buy it. The rally may
continue upto Rs. 30 and decline. If the
price falls the sell signal is given at 27 Rs.
i.e. 10% of Rs. 30 and the trader can take
up the short position till it reaches its low
level. When there is a rise in price the
same exercises have to be followed.

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Semi Strong Form of EMH

The semi strong form of the EMH centers on how
rapidly and efficiently market prices adjust to new
publicly available information. In this state, the
market reflects even those forms of information
which may be concerning the announcement of a
firms most recent earnings forecast and adjustments
which will have taken place in the prices of security.

The investor in the semi-strong form of the

market will find it impossible to earn a return on
the portfolio which is based on the publicly
available information in excess of the return
which may be said to be commensurate with the
portfolio risk.
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Semi Strong Form of EMH

Many empirical studies have been made
on the semi-strong form of the efficient
market hypothesis to study the reaction
of security prices to various types of
information around the announcement
time of the information.
Two studies commonly employed to test
semi-strong form efficient market are:
(1) Event study
(2) Portfolio study.
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Semi Strong Form of EMH

Event Study: It examines the market reactions
to and the excess market returns around a specific
information event like acquisition announcement or
stock split. The key steps involved in an event study
are as follows:
(1)Identify the event to be studied and pinpoint the
date on which the event was announced.
(2)Collect returns data around the announcement date.
In this context two issues have to be resolved: What
should be the period for calculating returns
weekly, daily, or some other interval? For how many
periods should returns be calculated before and
after the announcement date?
Cont
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Event Study Cont

(3) Calculate the excess returns, by period,
around the announcement date for each firm in
the sample. The excess return is calculated by
making adjustment for market performance
and risk.
(4) Compute the average and the standard error
of excess returns across all firms Assess
whether the excess returns around the
announcement date are different from zero.
(5) To determine whether the excess returns
around the announcement date are different
from zero, estimate the T statistic for each day.
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Semi Strong Form of EMH

Portfolio study: In a portfolio study, a
portfolio of stocks having the observable
characteristic (low price earnings ratio or
whatever) is created and tracked over time see
whether it earns superior risk-adjusted returns.
Steps involved in a portfolio study are as
follows:
(1) Define the variable (characteristic) on which
firms will be classified. The proposed investment
strategy spells out the relevant variable. The
variable must be observable, but not necessarily
numerical.
Cont..
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Portfolio Study Cont

(2) Classify firms into portfolios based upon the magnitude of
the variable.
(3) Collect data on the variable for every firm in the defined
universe at the beginning of the period and use that
information for classifying firms into different portfolios.
(4) Compute the returns for each portfolio on the returns for
each firm in each portfolio for the testing period and
calculate the return for each portfolio, assuming that the
stocks included in the portfolio are equally weighted.
(5) Calculate the excess returns for each portfolio. The calculation
of excess returns earned by a portfolio calls for estimating the
portfolio beta and determining the excess returns.
Cont..
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Portfolio Study Cont

(6) Assess whether the average excess returns are
different across the portfolios. Several statistical
tests are available to test whether the average
excess returns differ across these portfolios.
Some of these tests are parametric and some
nonparametric. Many portfolio studies suggest
that it is not possible to earn superior risk
adjusted returns by trading on some observable
characteristics. However, several portfolio
studies have documented inefficiencies and
anomalies.
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Strong Form of EMH

This market hypothesis holds that all available

information, public or private, is reflected in the
stock prices. The strong form is concerned with
whether or not certain individuals or groups of
individuals possess inside information which
can be used to make above average profits. If
the strong form of the efficient capital market
hypothesis holds, then and day is as good as
any other day to buy any stock. This the most
extreme form of the EMH. Most of the research
work has indicated that the efficient market
hypothesis in the strongest form does not hold
good.
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Strong Form of EMH

Empirical Evidence: Many of the tests of the strong

form of EMH deal with mutual fund performances.

Financial analysts have studied the risk adjusted rates
of return from hundreds of mutual funds and found
that the professionally managed funds are not able to
out perform the buy hold strategy.
Jensen had studied 115 funds over a decade. He
concluded that even though the analysts are well
endowed with wide ranging contacts and associations
in both the business and financial committees, they
are unable to forecast returns accurately enough to
recover the research and transaction costs. He holds
this, as a striking piece of evidence for the strong
form of EMH
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Market Efficiency and Anomalies

Anomalies are situations that appear to violate the
traditional view of market efficiency, suggesting that
it may be possible for careful investors to earn
abnormal returns. Some stock market anomalies
are:
(1) Low Price-Earnings Ratio: Stock that are selling at
price earnings ratios that are low relative to the market.
(2) Low Price-Sales Ratio: Stocks that have price-tosales ratios that are lower competed with other stocks in
the same industry or with the overall market.
(3) Low Price-to Book value Ratio: Stocks whose stock
prices are less that their respective book values.
Cont
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Market Efficiency and Anomalies

(4) High Dividend Yield: Stocks that pay high dividends
relative to their respective share prices.
(5) Small companies: Stock of companies whose
market capitalization is less than 100 million.
(6) Neglected Stocks: Stocks followed by only a few
analysts and/or stocks with low percentages of
institutional ownership.
(7) Stocks with High Relative Strength: Stocks whose
prices have risen faster relative to the overall market.
(8) January Effect: Stock do better during January than
during any other month of the year.
(9) Day of the Week: Stock of poorer during Monday
than during other days of the week.
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4/20/15

Thank
You

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