Market Efficiency

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Efficient Markets

How well do markets respond to new information?

Should it be possible to decide between a profitable
and unprofitable investment given current
information?
Efficient Markets
The prices of all securities quickly and fully reflect all
available information

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The current price of a stock reflects:

All known Information

Past information. Ex: last years earnings
Current information as well as events that have been
announced but forthcoming (such as share split)
Information that can reasonably be inferred. For
example: If many investors believe that interest
rates will decline soon, the prices will reflect this
belief before the actual decline occurs.

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Conditions for an Efficient Market

Large number of rational, profit-maximizing

investors
Actively participate in the market
Individuals cannot affect market prices
Information is costless, widely available,
generated in a random fashion
Investors react quickly and fully to new
information

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Consequences of Efficient Market

Quick price adjustment in response to the arrival of

random information makes the reward for analysis
low
Prices reflect all available information
Price changes are independent of one another and
move in a random fashion
New information is independent of past

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 Early literature: market prices incorporated new
information instantaneously.
Modern literature: it occurs very quickly. Brokerage
and institutional investors can access information
quickly than individual investors who can access
information through public media
Internet: investors have quick and cheap access to
information on continual basis

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Why stock market from developed market
can be expected to be efficient

A large number of rational-maximising investors exist

who actively participate in the market by analysing,
valuing and trading shares. These investors are price
takers, that is, one participant alone cannot affect the
price of security
Information is costless and widely available to market
participants at approximately the same time.
Information is generated in a random fashion such
that announcements are abasically independent of
one another
Investors react quickly and fully to new information,
causing share prices to adjust accordingly.
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In Emerging Market

Information tends to be scarer and less reliable in

many cases
Less well-developed flows of information
Have significant gaps in information

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Fama, E. F. (1969). Efficient Capital Markets: A Review of Theory and
Empirical Work. The Journal of Finance, 25(2), 383417.

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Market Efficiency Forms

Efficient market hypothesis

To what extent do securities markets quickly and
fully reflect different available information?
Three levels of Market Efficiency
Weak form - market level data
Semistrong form - public information
Strong form - all (nonpublic) information

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Weak Form

Prices reflect all past price and volume data

Technical analysis, which relies on the past
history of prices, is of little or no value in
assessing future changes in price
Market adjusts or incorporates this
information quickly and fully

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Semistrong Form

Prices reflect all publicly available

information
Investors cannot act on new public
information after its announcement and
expect to earn above-average, risk-adjusted
returns
Encompasses weak form as a subset

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Strong Form

Prices reflect all information, public and

private
No group of investors should be able to earn
abnormal rates of return by using publicly
and privately available information
Encompasses weak and semistrong forms as
subsets

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Evidence on Market Efficiency

Keys:
Consistency of returns in excess of risk
Length of time over which returns are earned
Economically efficient markets
Assets are priced so that investors cannot exploit any
discrepancies and earn unusual returns
Transaction costs matter

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Weak Form Evidence

Test for independence (randomness) of stock

price changes
If independent, trends in price changes do not
exist
Overreaction hypothesis and evidence
Test for profitability of trading rules after
brokerage costs
Simple buy-and-hold better

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Semistrong Form Evidence

Event studies
Empirical analysis of stock price behavior
surrounding a particular event
Examine company unique returns
The residual error between the securitys actual return and that
given by the index model
Abnormal return (Arit) =Rit - E(Rit)
Cumulative when a sum of Arit

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Abnormal Return

Abnormal Return: Return on a security beyond that expected on the

basis of its risk. =
Cumulative abnormal return (CAR): The sum of the individual
abnormal returns over the period under examination.
= =1

Calculating Expected Return, using Capital Asset Pricing Model

= +
Calculating Expected Return using Market Model
=

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 Semistrong Form Evidence
Stock splits
Implications of split reflected
in price immediately
following the announcement
Accounting changes
Quick reaction to real change
in value
Initial public offerings
Only issues purchased at
offer price yield abnormal
returns
Announcements and news
Little impact on price after
release
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Strong Form Evidence

Test performance of groups which have

access to nonpublic information
Corporate insiders have valuable private
information
Evidence that many have consistently earned
abnormal returns on their stock transactions
Insider transactions must be publicly
reported

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Implications of Efficient
Market Hypothesis

What should investors do if markets

efficient?
Technical analysis
Not valuable if weak form holds
Fundamental analysis of intrinsic value
Not valuable if semistrong form holds
Experience average results

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Implications of Efficient
Market Hypothesis

For professional money managers

Less time spent on individual securities
Passive investing favored
Otherwise must believe in superior insight
Tasks if markets informationally efficient
Maintain correct diversification
Achieve and maintain desired portfolio risk
Manage tax burden
Control transaction costs

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Market Anomalies

Exceptions that appear to be contrary to

market efficiency
Earnings announcements affect stock prices
Adjustment occurs before announcement but
significant amount after
Contrary to efficient market because the lag
should not exist

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Market Anomalies

Low P/E ratio stocks tend to outperform high

P/E ratio stocks
Low P/E stocks generally have higher risk-
adjusted returns
But P/E ratio is public information
Should portfolio be based on P/E ratios?
Could result in an undiversified portfolio

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Market Anomalies

Size effect
Tendency for small firms to have higher
risk-adjusted returns than large firms
January effect
Tendency for small firm stock returns to be
higher in January
Of 30.5% size premium, half of the effect
occurs in January

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Market Anomalies

Value Line Ranking System

Advisory service that ranks 1700 stocks
from best (1) to worst (5)
Probable price performance in next 12 months
1980-1993, Group 1 stocks had annualized
return of 19.3%
Best investment letter performance overall
Transaction costs may offset returns

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Behavioral Finance

Rationality as a principle of behavior

Are there systematic deviations from the
norms of rationality?
How do human beings make decisions?
Distortion throughout the process of decision-
making
In making predictions, perceiving the environment
Marriage of psychology and finance

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Conclusions About
Market Efficiency

Support for market efficiency is persuasive

Much research using different methods
Also many anomalies that cannot be explained
satisfactorily
Markets very efficient but not totally
To outperform the market, fundamental analysis
beyond the norm must be done

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Conclusions About
Market Efficiency

If markets operationally efficient, some

investors with the skill to detect a divergence
between price and semistrong value earn
profits
Excludes the majority of investors
Anomalies offer opportunities
Controversy about the degree of market
efficiency still remains

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