Capital Market Efficiency

Efficient Market Hypothesis

Learning Objectives

⚫ Understand the concept of market efficiency

⚫ Appraise with the investment implications of the

various levels of market efficiency

⚫ Develop a thorough understanding of the tests of

market efficiency and observed market anomalies
 https://timesofindia.indiatimes.com/business/india-

The downgrade
business/moodys-downgrades-india-rating-for-1st-time-in-22-
yrs/articleshow/76144694.cms

⚫ Country’s growth prospects

⚫ Stalled economic activity.
⚫ Less revenues
⚫ Higher Borrowings
⚫ Widening fiscal deficit to around 5.5%
⚫ Pressure on the rupee
⚫ Raise borrowing costs and dampen investor
sentiment
⚫ Lowe longer term growth
⚫ Persistent weak private sector investment
⚫ Tepid job creation and https://simplywall.st/stocks/pl/real-estate/wse-dvl/develia-shares/news/
shareholders-in-develia-wsedvl-have-lost-29-as-stock-drops-1
Introduction
⚫ An efficient capital market is a market that is efficient
in processing information.

⚫ In other words, the market quickly and correctly

adjusts to new information.

⚫ In an information of efficient market, the prices of

securities observed at any time are based on “correct”
evaluation of all information available at that time.

⚫ Therefore, in an efficient market, prices

immediately and fully reflect available information.
Efficient Market Theory
• An efficient capital market is one in which security prices
adjust rapidly to the arrival of new information
and, therefore, the current prices of securities reflect all
information about the security.

• In other words, in an efficient market at any point in time the

actual price of a security will be a good estimate of its
intrinsic value.

• Warren Buffet
⚫ Efficient capital markets and

⚫ Efficient market hypothesis

(EMH)
Efficient Market

⚫ Market price of the security is an unbiased estimate of

its intrinsic value.

⚫ But it does not mean that market price = intrinsic value

at every point of time.
Efficient Market
⚫ An “efficient” market is defined as a market where

⚫ there are large numbers of rational, profit-maximizers actively

competing,

⚫ with each trying to predict future market values of individual

securities, and

⚫ where important current information is almost freely available to

all
participants … on the average,

⚫ competition will cause the full effects of new information on

intrinsic
values to be reflected “instantaneously” in actual prices.
https://simplywall.st/stocks/in/diversified-financials/nse-mcx/multi-commodity-exchange-of-

india-shares/news/can-you-imagine-how-multi-commodity-exchange-of-indias-nsemcx-
shareholders-feel-about-the-31-share-price-increase/

⚫ It has been proven that markets are over-reactive

dynamic systems, and investors are not always rational.

⚫ One imperfect but simple way to consider how the

market perception of a company has shifted is to compare
the change in the earnings per share (EPS) with the share
price movement.

⚫ During the last year Multi Commodity Exchange of

India grew its earnings per share (EPS) by 104%.

⚫ This EPS growth is significantly higher than the 31%

increase in the share price
Two Types of Market
Efficiencies
 Operational efficiency

 Operational efficiency is measured by factors

like

 time taken to execute the order and

 the number of bad deliveries.

 Efficient market hypothesis does not deal with

this efficiency.
 Types of Market Efficiencies

 Informational efficiency

 Itis a measure of the swiftness or the market’s reaction

to new information.

 New information in the form of economic reports, company

analysis, political statements and announcement of new
industrial policy is received by the market frequently.

 Security prices adjust themselves very rapidly and accurately.

The Efficient Markets Hypothesis

⚫ The Efficient Markets Hypothesis (EMH) is made up of

three progressively stronger forms:

⚫ Weak Form
⚫ Semi-strong Form
⚫ Strong Form

The level of information being considered in the market

is the basis for this segregation.
The EMH Graphically
All historical prices and returns
⚫ In this diagram, the circles
represent the amount of Strong Form
information that each form of
the EMH includes.
Semi-Strong
⚫ Note that the weak form covers
the least amount of information,
and the strong form covers all Weak Form
information.
⚫ Also note that each successive
form
includes the previous ones.

All information, public and private

All public information
EMH INDIA
⚫ https://marcellus.in/blogs/how-psu-stocks-disprove-the-

efficient-markets-hypothesis/
The Weak
Form
⚫ The weak form of the EMH says that past prices, volume, and
other market statistics provide no information that can be
used to predict future prices.

⚫ If stock price changes are random, then past prices cannot be

used
to forecast future prices.

⚫ Price changes should be random because it is information

that
drives these changes, and information arrives randomly.
The Weak Form
Cont..
⚫ Prices should change very quickly and to the
correct level when new information arrives.

⚫ This form of the EMH, if correct, repudiates

technical analysis.

⚫ Most research supports the notion that the markets

are weak form efficient.
The Semi-strong
Form
⚫ The semi-strong form says that prices fully reflect all publicly
available information and expectations about the future.

⚫ This suggests that prices adjust very rapidly to new

information, and that old information cannot be used to earn
superior returns.

⚫ The semi-strong form, if correct, repudiates fundamental

analysis.

⚫ Most studies find that the markets are reasonably efficient in

this sense, but the evidence is somewhat mixed.
⚫ Semi-strong form efficiency would mean that no
investor would be able to outperform the market with
trading strategies based on publicly available
information.

⚫ Abnormal returns on investment when information

is nor publicly available

⚫ Semi strong efficient, the period after a favorable

(unfavorable) event would not generate returns beyond
(less than) what is suggested by an equilibrium pricing
model
The Strong Form
⚫ The strong form says that prices fully reflect all
information, whether publicly available or not.

⚫ Even the knowledge of material, non-public

information cannot be used to earn superior
results.

⚫ no one can earn excess returns.

⚫ Most studies have found that the markets are not efficient
in this sense.
The Strong Form
Example
⚫ To ascertain whether insiders of a firm are able to
make superior returns compared to the market.

⚫ Absence of superior return by the insiders would imply

that the market is strongly efficient.
Summary of Tests of the
EMH
⚫ Weak form is supported, so technical analysis cannot
consistently outperform the market.

⚫ Semi-strong form is mostly supported , so fundamental analysis

cannot consistently outperform the market.

⚫ Strong form is generally not supported. If you have secret

(“insider”) information, you CAN use it to earn excess returns
on a consistent basis.
 Pani
c
⚫ A trade in the bond markets, where DSP Mutual Fund
sold NCDs of DHFL at a higher yield, triggered
speculation that there could be ratings downgrade in the
housing finance company.

⚫ Sold DHFL worth ₹300 crore at a yield of 11%.

⚫ Speculation of liquidity issues

⚫ Redemption Pressures

https://economictimes.indiatimes.com/markets/stocks/news/dhfl-paper-sale-by-dsp-
triggered-panic/articleshow/65908110.cms
 DSP Statement
⚫ DSP’s Parekh denied the fund is seeing redemption pressure.

“We have been bringing down duration in our fixed income portfolios
in line with our view on interest rates.We are reducing duration
across maturities and across issuers. In September, liquid and money
market funds see outflows on account of advance tax payments and as
a fund house we budget for it.There is no redemption pressure on us
and our flows are in line with the market. Our average AUM (asset
under management) continues to be around ₹95,000 crore, which is
nearly the same as last month,” said Parekh.
 IL&FS Fiasco
⚫ The company has over `90,000 crore of debt—estimated to
be over 18 times its equity.

⚫ returns cannot fund payments to creditors.

⚫ classic case of mismanagement, alleged malfeasance,

shareholder somnolence, reckless rating and regulatory
forbearance.

⚫ Despite its balance sheet being afflicted with debt,

leverage, incomplete projects and receivables, the
shocking fact is that IL&FS enjoyed AA+ rating till
September 9
Market Depth
⚫ Put call
ratio

⚫ India Vix
Quiz
⚫ If you believe in the form of the EMH,
you believe that stock prices reflect all relevant
information including historical stock prices and
current public information about the firm, but not
information that is available only to insiders.

A. semistrong
B.strong
C. weak
D.semistrong, strong, and weak
Quiz
⚫ If you believe in the form of the EMH, you
believe that stock prices only reflect all information that
can be derived by examining market trading data such as
the history of past stock prices, trading volume or short
interest.

A. semistrong
B.strong
C. weak
D.semistrong, strong, and weak
Quiz
⚫ below which it is difficult for the market to fall.

A.An intrinsic value is a value

B.A resistance level is a value
C.A support level is a value
D.An intrinsic value and a resistance level are values
Quiz
⚫ Present value of dividends which is expected to be
provided in future is classified as an

a) intrinsic value of stock

b) extrinsic value of stock
c) intrinsic bonds
d) extrinsic bonds
Quiz
⚫ Which of the following statements is true?

a) In a strong form efficient market, there are no

mispriced assets.
b) In a semi - strong form efficient market, all
information is equally available to all investors.
c) II only. neither I nor II.
d) both I and II. I only.
 The Runs Test

The runs test is a statistical procedure used to determine

whether the pattern of occurrences of two types of
observations is determined by a random process.
 The Runs Test

A run is a succession of occurrences of a certain type

preceded and followed by occurrences of the alternate
type or by no occurrences at all.
 The Runs Test

Runs are to find out whether the series of price

movements have occurred by chance.

A run is an uninterrupted sequence of the same

observation.
 Run
test
⚫ An increase in price is represented by +

⚫ The decrease in price is represented by –

⚫ When there is no change in price, it is represented by zero.

A consecutive sequence of some sign is considered as run changes of

sign
indicates new run.
Large Sample Runs Test

TEST
STATISTIC

r  r
z
r
 n1 = Number of occurrences of first type
n2 = Number of occurrences of second type

MEAN AND STANDARD DEVIATION

FOR r
2n1n2
r  1
n1  n 2
(2n1n2 )(2n1n2  n1 
 r  (n  n )2 (n  n
n2 )
1)
1 2 1 2
The Runs Test
Exampl
e
Price Price Price Price
43.05 47.4 60.3 56.4
43.4 52.15 59.65 57.15
41.75 52.5 58.65 57.25
42.65 53.45 56.8 57.55
43.6 57.55 53.5 56.75
43.05 57.45 51.5
43.4 55.9 48.4
46.8 54.15 52.3
46.6 54.7 56.05
47.5 58.95 55.15
 Probability Theory
95% of the area under the normal curve lies within +-1.96 S.D of the
Mean.

Rejection Region Rejection Region

 / 2 = 0.025  / 2 = 0.025

z.025  1.96 0 z.025  1.96

r  r 16 17.6
z 
r 2.83  .565

Since z= -.565 > -1.96 and < 1.96, the run are
occurred by chance,
⚫ Departure from EMH

⚫ Serial Correlations tests are related with Weak

form of efficiency

⚫ Event studies are related with semi strong form of

market efficiency
Departures from the
EMH
⚫ Not efficient in Weak Form

⚫ Momentum effect

⚫ Predictability of future returns based on certain

events

⚫ Quantification of EMH

https://www.motilaloswal.com/article.aspx/1304/
Is-the-stock-market-always-right-in-its-judgement
⚫ Irrational investors would be exploited by the rational
traders, and would eventually lose out in the market,
leading to their exit.

⚫ The market was expected to evolve as efficient.

⚫ Reverse is happening as irrational traders are making

profits on the expense of rational traders.
Calendar Effects as departure
⚫ January Effect

⚫ Various day-of-the-week effects/Weekend Effect

Returns on Monday are expected to be different, given that they

are across Friday-end-to-Monday-morning, a much longer period
than any other day, and hence with more information.

⚫ Behavioral finance
Behaviour of markets based on various sources and forms
of
investor irrationality are collectively known as behavioral
finance.
Behavioral finance Anomaly Departure

It implies that

⚫ (i) The estimation of expected returns based on methods such

as the capital asset pricing model is unreliable, and

⚫ (ii) There could be many profitable trading strategies based on

the collective irrationality of the markets.

⚫ Exploiting market opportunities

⚫ Arbitrage