Chapter 06

EFFICIENT CAPITAL MARKETS

 Efficient Capital
Markets
In an efficient capital market, security
prices adjust rapidly to the arrival of new
information, therefore the current prices
reflect all information about the security
Whether markets are efficient has been
extensively researched and remains
controversial
 Why Should Capital
Markets Be Efficient?
What would be the ingredients of an
“informationally” efficient market?
 A large number of profit-maximizing participants
analyze and value securities
 New information regarding securities comes to the
market in a random fashion
 Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
 Price adjustments may be imperfect but unbiased.
Under these conditions, a security’s price would
be appropriate for its level of risk.
 Alternative Efficient
Market Hypotheses
The various forms of the efficient market
hypothesis differ in terms of the
information that security prices should
reflect.
Weak-form EMH
Semistrong-form EMH
Strong-form EMH
 Weak-Form EMH
Current prices fully reflect all security-
market information, including the
historical sequence of prices, rates of
return, trading volume data, and other
market-generated information
This implies that past rates of return and
other market data should have no
relationship with future rates of return
Semistrong-Form EMH
Current security prices reflect all public
information, including market and non-
market information
This implies that decisions made on
new information after it is public should
not lead to above-average risk-adjusted
profits from those transactions
 Implications of the
Semistrong-Form EMH
If the market is efficient
in this sense,
information in The Wall
Street Journal, other
periodicals, and even
company annual reports
is already fully reflected
in prices, and therefore
not useful for predicting
future price changes.
 Strong-Form EMH
Stock prices fully reflect all information from
public and private sources
This would require perfect markets in which
all information is cost-free and available to
everyone at the same time
Implication: Not even “insiders” would be able
to “beat the market” on a consistent basis
 Tests and Results:
Weak-Form EMH
Two Approaches
Statistical tests of independence between rates of
return - the tests used to examine the weak form of
the EMH test for the independence assumption.
Examples of these tests are the autocorrelation
tests (returns are not significantly correlated over
time) and runs tests (stock price changes are
independent over time)
Tests of trading rules
 Tests and Results:
Weak-Form EMH
Statistical tests of independence
between rates of return
 Autocorrelation tests
 Mostly support the weak-form EMH and
indicate that price changes are random
 Some studies using more securities and more
complicated tests cast some doubt
 Runs tests
 Indicate randomness in prices
 Tests and Results:
Weak-Form EMH
Comparison of trading rules to a buy-
and-hold policy
 Some filter rules seem yield above-
average profits with small filters, but only
before taking into account the substantial
transactions costs involved
 Trading rule results have been mixed, and
most have not been able to beat a buy-
and-hold policy
 Tests and Results:
Weak-Form EMH
Problems with tests
Cannot be definitive since trading rules can
be complex and there are too many to test
them all
Testing constraints
 Use only publicly available data
 Should include all transactions costs
 Should adjust the results for risk (an apparently
successful strategy may just be a very risky
strategy)
 Conclusions:
Weak-Form EMH
Results generally support the weak-
form EMH, but results are not
unanimous
 Some strategies too subjective to test
 Not all trading rules are disclosed
 If you had a trading strategy that worked, would
you reveal it?!
 Tests and Results:
Semistrong-Form EMH
The semi-strong form EMH implies that the market
is efficient, reflecting all publicly available
information
It assumes that stocks adjust quickly to absorb
new information and also incorporates the weak-
form hypothesis
Investors purchase stocks after this information is
released, they cannot benefit over and above the
market by trading on new information
 Tests and Results:
Semistrong-Form EMH
Two different sets of tests:
Studies to predict future rates of return using
available public information
a) Time-series analysis of returns
b) Cross-section distribution of returns
Event studies examine how fast stock prices
adjust to significant economic events
Tests involve the estimation of “abnormal
returns,” where expected abnormal returns
are zero in an efficient market.
 Tests and Results:
Semistrong-Form EMH
Tests often involve “market-adjusted returns,”
created by subtracting the market return from
the security’s return, thereby defining a
security’s “abnormal return:”
ARit = Rit - Rmt
where:
 ARit = abnormal return on security i during period t

 Rit = return on security i during period t

 Rmt = return on a market index during period t
 Tests and Results:
Semistrong-Form EMH
The stock experienced a 5 percent
increase while the market increased 10
percent, the stock’s abnormal return
would be -
 Tests and Results of
Semistrong-Form EMH
Another definition of abnormal return is a “risk-
adjusted return” or “market model” which
adjusts for the security’s own required rate of
return, given its systematic risk (as measured
by beta):
ARit = Rit - E(Rit)
where:
 E(R ) = the expected rate of return for stock i during
it
period t based on the market rate of return and the
stock’s normal relationship with the market (its beta)
 Tests and Results of
Semistrong-Form EMH
A stock beta of 1.20 and a market return
of 10 percent. The stock that was
expected to have a 12 percent return had
only 5 percent return, the stock’s
abnormal return would be -
 Tests and Results:
Semistrong-Form EMH
Time series tests for predictability of returns and
profit opportunities
Quarterly earnings reports information
 Unanticipated earnings changes or “earnings
surprises” are not immediately reflected in security
prices
The January Anomaly (A “calendar” effect)
 Large returns in January present opportunities to
purchase in December, and sell in January and
earn abnormal returns.
 Tests and Results:
Semistrong-Form EMH
Other calendar effects
 All the market’s cumulative advance occurs
during the first half of trading months
 Monday/weekend returns were significantly
negative
 For large firms, the negative Monday effect
occurred before the market opened (it was
a weekend effect), whereas for smaller
firms, most of the negative Monday effect
occurred during the day on Monday (it was
a Monday trading effect)
 Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
In an efficient market, all securities should
have equal risk-adjusted returns
These studies examine alternative measures
of size or quality as a tool to rank stocks in
terms of risk-adjusted returns
 These tests include a joint hypothesis of both
market efficiency and the asset pricing model used
to generate abnormal returns
 Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
Price-earnings ratios
 Examine historical P/E ratios and returns
 Low P/E stocks had higher risk-adjusted returns
than high P/E stocks
 Publicly available P/E ratios could be used for
abnormal returns
Price-earnings/Growth (PEG) ratios
 Mixed results
 Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
The size effect
 The risk-adjusted returns for extended periods
indicate that the small firms consistently
experienced significantly larger risk-adjusted
returns than large firms
 Abnormal returns could occur because either
markets are inefficient or the market model is not
properly specified and provides incorrect
estimates of risk and expected returns (joint test)
 Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
The size effect
 Adjustments for riskiness of small firms did not
explain the large differences in rate of return
 The impact of transactions costs of investing in
small firms is substantial (takes away the
differential with a short-term trading strategy)
 Even after risk and transaction costs, small firms
outperform large firms with annual trading
 Tests and Results:
Semistrong-Form EMH
Neglected Firms
 Firms divided by number of analysts
following a stock
 Small-firm effect was confirmed
 Neglected firm effect caused by lack of
information and limited institutional interest
 Neglected firm concept applied across size
classes
 Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
Book value-market value (BV/MV) ratio- The
ratio relates the BV of a firm’s equity to the MV of its
equity
 Significant positive relationship between the
current values for this ratio and future stock
returns
Although various measures including the P/E ratio
seem to help predict future returns, the size effect
and BV/MV ratio have the greatest predictive ability.
 Tests and Results:
Semistrong-Form EMH
Event studies
Event studies examine abnormal returns
surrounding various events
Stock split studies
 Mostly show no positive impact on returns
because of a stock split
Initial public offerings (IPOs)
 Significant IPO underpricing, but it quickly adjust
away in the first day, consistent with the EMH
 Summary on the
Semistrong-Form EMH
Evidence is mixed
Strong support of the EMH from numerous
event studies
Strong evidence against the EMH from both
time series and cross-sectional studies
 Dividend yields, earnings surprises, calendar
effects
 The size effect, BV/MV, P/E ratios, etc.
 Tests and Results:
Strong-Form EMH
Testing Groups of Investors
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
 Tests and Results:
Strong-Form EMH
Corporate Insiders
Insiders include major corporate officers,
directors, and owners of 10% or more of any
equity class of securities
Insiders must report to the SEC each month
on their transactions as insiders
These insider trades are made public about
six weeks later and allow for study
 Tests and Results:
Strong-Form EMH
Corporate Insiders
Mixed results
Corporate insiders generally experience
above-average profits especially on purchase
transactions
 This implies that many insiders had private
information from which they derived above-
average returns on their company stock
Later studies indicate that insiders may no
longer be able to generate abnormal returns
 Tests and Results:
Strong-Form EMH
Stock Exchange Specialists
Specialists have monopolistic access to
information
You would expect specialists to derive
above-average returns because of their
superior information, and this appears
to be the case.
 Tests and Results:
Strong-Form EMH
Security Analysts
Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
This looks at whether, after a stock selection
by an analyst is made known, a significant
abnormal return is available to those who
follow their recommendation
 Tests and Results:
Strong-Form EMH
Professional Money Managers
Trained professionals, working full time at
investment management
If any investor can achieve above-average
returns, it should be this group
If any non-insider can obtain inside
information, it would be this group due to the
extensive management interviews that they
conduct
 Summary on the
Strong-Form EMH
Mixed results
Some strong support
 Professional money managers
Some strong evidence against the EMH
 Tests for corporate insiders and stock exchange
specialists do not support the hypothesis
 Both groups seem to have monopolistic access to
important information and use it to derive above-average
returns
 Behavioral Finance
A growing field of study in finance.
Rather than assuming ultra-rational behavior,
the area of behavioral finance seeks to
incorporate how humans actually behave.
 Incorporates the ways in which psychology may
impact investment decisions
 It has been useful for explaining various
“anomalies” that we observe in decision-making
that are difficult to reconcile with rationality
 Behavioral Finance
Using psychological biases to explain behavior
 Why do investors display overconfidence in
forecasts?
 Can be explained by the confirmation bias
 Why do investors tend to put more money into
failing investments?
 Can be explained by the escalation bias
Implications of Market
Efficiency
Overall results indicate the capital markets
are efficient as related to numerous sets of
information
There are substantial instances where the
market fails to rapidly adjust to public
information
 So, what techniques will or won’t work?
 What do you do if you can’t beat the market?
Efficient Markets and
Portfolio Management
Does active portfolio management pay
off?
 Research indicates that most money
managers do keep pace with the market
Certainly with a superior analyst,
recommendations should be followed
 Opportunities may be present in smaller,
neglected stocks (although risk must be
taken into account)
Efficient Markets and
Portfolio Management
Without superior analysts, passive
management may outperform active
management
 Build a globally diversified portfolio with a
risk level matching client preferences
 Minimize transaction costs (taxes, trading
turnover, liquidity costs)
 The Rationale and
Use of Index Funds
Efficient capital markets and a lack of
superior analysts imply that many portfolios
should be managed passively (so their
performance matches the aggregate market,
minimizes the costs of research and trading)
Institutions created market (index) funds
which duplicate the composition and
performance of a selected index series
Insights from Behavioral
Finance
There may be trading opportunities
created by persistent investor biases
and “herd mentality”
 Supports the notion of contrarian
investment strategies
 Some mutual funds employ behavioral
finance strategies
Thank You