EFFICIENT

MARKET
HYPOTHESIS
THE COLLECTIVE
WISDOM

CHAPTER 9
EFFICIENT MARKET HYPOTHESIS

• In the mid-1960s, Eugene Fama introduced the idea of an "efficient" capital market to the literature of financial
economics. Put simply, the idea is that the intense competition in the capital market leads to fair pricing of debt
and equity securities. 
• Benjamin Friedman refers to efficient market hypothesis as a "credo", a statement of faith and not a scientific
proposition. 
• Warren Buffett, perhaps the most successful investor of our times, has characterized the market as "a slough of
fear and greed untethered to corporate realities". 
• For most financial economists, however, the efficient market hypothesis is a central idea of modern finance that
has profound implications.
RANDOM WALK AND EFFICIENT MARKET
HYPOTHESIS
Surprise discover
• In 1953, Maurice Kendall', a distinguished statistician, presented a somewhat unusual paper before the Royal Statistical
Society in London. Kendall examined the behavior of stock and commodity prices in search of regular cycles. Instead of
discovering any regular price cycle, he found each series to be "a wandering one, almost as if once a week the Demon of
Chance drew a random number and added it to the current price to determine the next week's price." Put differently,
prices appeared to follow a random walk, implying that successive price changes are independent of one another. 
• In 1959, two highly original and interesting papers supporting the random walk hypothesis were published. In one paper,
Harry Roberts showed that a series obtained by cumulating random numbers bore resemblance to a time series of stock
prices. In the second paper, Osborne, an eminent physicist, found that stock price behavior was similar to the movement
of very small particles suspended in a liquid medium-such movement is referred to as the Brownian motion.
RANDOM WALK AND EFFICIENT
MARKET HYPOTHESIS
• A random walk means that successive stock prices are independent and identically distributed.
Therefore, strictly speaking, the stock price behavior should be characterized as a sub martingale,
implying that the expected change in price can be positive because investors expect to be
compensated for time and risk. Further, the expected return may change over time in response to
change in risk. 
• Inspired by the works of Kendall, Roberts, and Osborne, a number of researchers employed
ingenious methods to test the randomness of stock price behavior. By and large, these tests have
vindicated the random walk hypothesis. Indeed, in terms of empirical evidence, very few ideas in
economics can rival the random walk hypothesis. 
SEARCH FOR  THEORY

• When the empirical evidence in favor of the random walk hypothesis seemed overwhelming, the academic researchers
asked the question: "What is the economic process that produces a random walk?" They concluded that the randomness
of stock prices was the result of an efficient market. Broadly, the key links in the argument are as follows:
 Information is freely and instantaneously available to all the market participants.
 Keen competition among market participants more or less ensures that market prices will reflect intrinsic values. This
means that they will fully impound all available information.
 Prices change only in response to new information that, by definition, is unrelated to previous information (otherwise it
will not be new information).
 Since new information cannot be predicted in advance, price changes too cannot be forecast. Hence, prices behave like a
random walk.
WHAT IS AN EFFICIENT MARKET?

• An efficient market is one in which the market price of a security is an unbiased estimate of its
intrinsic value. Note that 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
uncorrelated 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.
THREE LEVELS OF MARKET EFFICIENCY

Market efficiency is defined in relation to information that is reflected in security prices. Eugene Fama
suggested that it is useful to distinguish three levels of market efficiency:
• Weak-form efficiency - Prices reflect all information found in the record of past prices and volumes. 
• Semi-strong form efficiency - Prices reflect not only all information found in the record of past prices and
volumes but also all other publicly available information. 
• Strong-form efficiency - Prices reflect all available information, public as well as private. 
Richard Roll adds his own nuance. According to him market efficiency doesn't mean that prices reflect all
information or even publicly available information. Rather it implies that the link between unreflected
information and prices is so subtle and tenuous that it cannot be easily costlessly detected.
MISCONCEPTIONS ABOUT  THE EFFICIENT
MARKET HYPOTHESIS
The efficient market hypothesis has often been misunderstood. The common misconceptions about the efficient
market hypothesis are stated below along with the answers meant to dispel them. 

Misconception: The efficient market hypothesis implies that the market has perfect forecasting abilities. 
Answer - The efficient market hypothesis merely implies that prices impound all available information. This
does not mean that the market possesses perfect forecasting abilities. 

Misconception: As prices tend to fluctuate, they would not reflect fair value. 
Answer- Unless prices fluctuate, they would not reflect fair value. Since the future is uncertain, the market is
continually surprised. As prices reflect these surprises they fluctuate. 
MISCONCEPTIONS ABOUT THE EFFICIENT
MARKET HYPOTHESIS
Misconception : Inability of institutional portfolio managers to achieve superior investment
performance implies that they lack competence. 
Answer- In an efficient market, it is ordinarily not possible to achieve superior investment performance.
Market efficiency exists because portfolio managers are doing their job well in a competitive setting. 

Misconception: The random movement of stock prices suggests that the stock market is irrational. 
Answer - Randomness and irrationality are two different matters. If investors are rational and
competitive, price changes are bound to be random.
EMPIRICAL EVIDENCE

EMPIRICAL EVIDENCE ON WEAK-FORM EFFICIENT MARKET

HYPOTHESIS
• The weak-form efficient market hypothesis says that the current price of a stock reflects all
information found in the record of past prices and volumes. This means that there is no relationship
between the past and future price movements.
RETURNS OVER SHORT HORIZONS

• The earlier test of weak-form efficient market hypothesis looked at randomness in the short run.
Three types of tests have been commonly employed for this purpose: 

(a) serial correlation tests

(b) runs tests
(c) filter rules tests.
RETURNS OVER SHORT HORIZONS

• Serial Correlation Tests - One way to test for randomness in stock price changes is to look at their
serial correlations (also called auto-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. Initial subsequent studies have failed
to discover any significant serial correlations. Subsequent studies discovered minor positive
correlations.
RETURNS OVER SHORT HORIZONS
• Runs Tests - Given a series of stock price changes, each price change is designated as a plus (+) if it represents an
increase or a minus (-) if it represents a decrease. The resulting series, for example, may look as follows: 

++ - ++ - - +
• A run occurs when there is no difference between the sign of two changes. When the sign of change differs, the run
ends and a new run begins. For example, in the above series of pluses and minuses, there are five runs as follows:

• To test a series of price changes for independence, the number of runs in that series is compared to see whether it is
statistically different from the number of runs in a purely random series of the same size. Many studies have been carried out,
employing the 'runs test' of independence. By and large, the results of these studies seem to strongly support the random walk
model.
RETURNS OVER SHORT HORIZONS

• Filter Rules Test - An n percent filter rule may be defined as follows: "If the price of a stock
increases by at least n percent, buy and hold it until its price decreases by at least n percent from a
subsequent high. When the price decreases by at least n percent or more, sell it."
• If the behavior of stock price changes is random, filter rules should not outperform a simple buy-
and-hold strategy. Many studies have been conducted employing different stocks and different filter
rules. By and large, they suggest that filter rules do not outperform a simple buy-and-hold strategy,
particularly after considering the commissions on transactions
RETURNS
OVER LONG
HORIZONS

 
• while returns over short horizons are characterized
by minor positive correlation, return over long
horizons seem to be characterized by pronounced
negative serial correlation.
EMPIRICAL
EVIDENCE
OM SEMI-
STRONG
FORM
EFFICIENT • holds that stock prices adjust rapidly to all publicly
MARKET available information . This implies that using
publicly available information investors will not
able to earn superior risk-adjusted.
EVENT STUDY

- examines the market reaction 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: 
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. 
3. Calculate the excess returns, by period, around the announcement date for each firm in the sample. 
4. Compute the average and the standard error of excess returns across all firms. 
5. Assess whether the excess returns around the announcement date are different from zero.
EVENT STUDY

• Identify the event to be studied and pinpoint the date on which the event was announced.
- Event studies presume that the timing of the event can be specified with a fair degree of precision.
Because financial markets react to the announcement of an event, rather than the event itself, event
studies focus on the announcement date of the event.
EVENT STUDY

• 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?
EVENT STUDY

• 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. For example,
if the capital asset pricing model is employed to control for risk the excess return is calculated as:
EVENT STUDY

• Compute the average and the standard error of excess returns across all firms. 
- The average excess return is 

The standard error of the excess return is the standard deviation of the sample average.
EVENT STUDY

• Assess whether the excess returns around the announcement date are different from zero.
To determine whether the excess returns around the announcement date are different from zero, estimate
the T statistic for each day:

Statistically significant T statistics imply that the event has a bearing on returns; the sign of the excess
return indicates whether the effect is positive or negative.
RESULTS OF
PORTFOLIO
STUDIES

• many portfolio studies suggest that is not possible to

earn superior risk-adjusted returns by trading on
some observable characteristics .
EMPIRICAL
EVIDENCE
ON THE
STRONG
FORM
EFFICIENT
MARKET
• holds that all available information, public or
private, is reflected in the stock prices
RESULTS OF EVENT STUDIES

The results of event studies are mixed. Most event studies support the semi-strong form efficient market hypothesis. Two
examples may be cited:
• Fama, Fisher, Jensen, and Roll' examined the effect of stock splits on returns for 940 stock splits on the New York Stock
Exchange for the period 1927-1959. They found that prior to the split, the stocks earned higher returns than predicted by the
market model. After the split, however, stocks earned returns which were more or less in conformity with the market model.
• Ball and Brown' studied the effect of annual earnings announcements. They divided firms into two groups. The first group
consisted of firms whose earnings increased in relation to the average corporate earnings and the second group consisted of
firms whose earnings decreased in relation to the average corporate earnings. They found that before the announcement of
earnings, stocks in the first group earned positive abnormal returns whereas stocks in the second group earned negative
abnormal returns. After the announcement of earnings, however, stocks in both groups earned normal returns.
RESULTS Several event studies, however, have cast their shadow
over the validity of the semi- strong form efficient
OF EVENT markets theory.

STUDIES One example may be cited:

• A study conducted by V.L. Bernard and J.K.

Thomas" found that stock prices adjust gradually,
not rapidly, to announcements of unanticipated
changes in quarterly earnings.
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 to see whether it earns superior risk adjusted returns. The basic 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. Note that the variable must be observable, but not necessarily numerical. Examples: price- earnings ratio,
company size, price-book value ratio, bond ratings, and so on. 
2. Classify firms into portfolios based upon the magnitude of the variable. 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. For
example, if the price-earnings ratio is the screening variable, classify firms on the basis of the price-earnings ratio into
portfolios from the lowest price-earnings class to the highest price-earnings class. The size of the universe will determine the
number of classes.
PORTFOLIO STUDY
3. Compute the returns for each portfolio. Collect information 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.

4. Calculate the excess returns for each portfolio. The risk-return model commonly employed for calculating the
excess returns is the capital asset pricing model. So the calculation of excess returns earned by a portfolio calls for
estimating the portfolio beta and determining the excess returns:

* Note that the beta of a portfolio is estimated by taking the average of the betas of the individual stocks in the portfolio or by
regressing the returns on the portfolio against market returns over some prior time period (for example, the year before the
testing period).
PORTFOLIO STUDY

5. 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.

Results of portfolio studies - many portfolio studies suggest that is not possible to earn superior risk-
adjusted returns by trading on some observable characteristics.
EMPIRICAL EVIDENCE ON THE STRONG
FORM EFFICIENT MARKET
• holds that all available information ,public or private ,is reflected in the stock prices.

Empirical Evidence suggest the following: 

1. Corporate insiders and stock exchange specialist earn superior rates of return after adjustment for
risk. 
2. Mutual fund managers do not ,on an average, earn a superior rate of return 
PRICE OVERREACTIONS

• the negative correlation in prices on account of such behavior seem to provide profit opportunities
from "contrarian" trading strategies.
CALENDAR ANOMALIES, EXCESS VOLATILITY
AND NORMAL RANGE OF INTERESTS RATES

• Calendar Anomalies - Researchers have found some seasonal patterns. One well documented
anomaly is the " week-end effect ". 
• Excess Volatility - Robert Shiller and others have argued that investors pursue facts and behave like
a herd. As a result stock market overreacts to events. 
• Normal Range of Interests Rates - Market interest rates move within a normal range. Hence when
interest rates are close to the high end of the range they are likely to decrease.
THE CRASH OF 1987

• On October 19, 1987, the Dow Jones Industrial Average, the most widely followed stock market index of
the US or the whole world, crashed by 23 percent in one day. There was obviously no new fundamental
information to justify such a dramatic decline in stock prices. Hence the idea that the market price reflects
intrinsic value appears less appealing. Were the prices irrationally high before the Black Monday or
irrationally low afterward?
• The events of 1987 suggest how difficult it is to value equity stocks. To illustrate the problem, suppose that
an equity stock is expected to pay a dividend of Rs. 3 a year hence and the dividend would grow at a
constant rate every year. Investors require a return of 16 percent on this stock and the market price of the
stock is Rs. 100. Applying the constant growth dividend discount model (see Chapter 13) we can figure out
the expected growth in dividends:
THE CRASH OF 1987
• An identical fall would occur, if the investors revise their required return upward by 1 percent to 17 percent, holding
their growth expectation constant. Thus we find that 1 percent decline in the expected growth rate or 1 percent
increase in the investors' required return leads to a fall of 25 percent in the stock price.
• The difficulty in valuing equity stocks has two implications. First, investors typically price an equity stock in relative
terms - relative to its price yesterday or relative to the price of comparable securities. They assume yesterday's price as
correct and adjust it upward or downward based on today's information. Thus, when investors lose faith in the
benchmark of yesterday's price, there may be a substantial revision in prices before a new benchmark is determined.
THE CRASH OF 1987

• Second, it is almost impossible to test the hypothesis that the stock price is equal to the intrinsic
value, as it is very difficult to establish the intrinsic value without any reference to price. Though the
crash has not conclusively disproved the efficient market hypothesis, it has undermined the faith of
many people in efficient market hypothesis.
• Even though the crash may cast some shadow over market efficiency with respect to absolute prices,
it does not weaken the case for market efficiency with respect to relative prices. Put differently,
while we may not be sure whether prices of two stocks, viz. A and B are fairly established in any
absolute sense, we can be reasonably confident the prices of A and B are fairly established relative to
each other.
SEMI-
EFFICIENT
MARKET
HYPOTHESIS

• The efficient market hypothesis (EMH) has a

cousin, the semi-efficient market hypothesis
(SEMH), SEMH holds that some stocks are priced
more efficiently than others.
WHAT IS THE
VERDICT?

• Despite the anomalies and puzzles and the challenge

of behavioralists and their sympathizers, the
substantial evidence in favor of the efficient market
hypothesis cannot be gain said.
WHY THE
DEBATE • Selection Bias- Suppose you discover an investment
PERSISTS? schemes that produces superior returns.

• Role of chances- Since large numbers of people

participate in the field of investment, some investors
are bound to perform well due to the chance factor.
IMPLICATIONS FOR INVESTMENT
ANALYSIS
Let us briefly recapitulate the main points:
1.The logical development of the efficient market hypothesis, given certain assumptions, is virtually
unassailable. However, the hypothesis rests on assumptions that are somewhat fragile. 
2. The empirical evidence regarding the randomness of stock price behavior seems to be
overwhelming. 
3. The market often adjusts rapidly to public information. Yet on many occasions it assimilates
information rather slowly. 
4. The market is rational and orderly in many ways. However, it has its own quirks and flaws.
IMPLICATIONS FOR INVESTMENT ANALYSIS
INVESMENT IMPLICATIONS OF  THE OBSERVATION

1. The substantial evidence in favor of the randomness of stock price behavior suggests that technical analysis (which is based on the
premise that stock prices follow certain patterns) represent useless market folklore. 
2. Routine and conventional fundamental analysis is not of much help in identifying profitability courses of action, more so when
you are looking at actively traded securities. 
3. The key levers for earning superior rates of return: 
* Early action on any new development. 
* Sensitivity to market imperfections and anomalies
* Use of original, unconventional, and innovative modes of analysis. 
* Access to inside information and its sensible interpretation. 
* An independent judgment that's  not affected by market psychology.
IMPLICATIONS FOR INVESTMENT ANALYSIS
INVESMENT IMPLICATIONS OF  THE OBSERVATION

4. Only incisive analysis and uncommon techniques are likely to provide an edge in fundamental
analysis. 
5. Often active portfolio management may not be a worthwhile activity as it may not be possible to
justify the expenses associated with it.
6. It is tempting to believe that in an efficient market you can choose a portfolio by simply throwing
darts at the quotations page of Economic Times.
 CAPUA, MARIAN

FAUSTINO, MICHELLE

PINEDA, MARY LIANYZETTE

GROUP 9