EFFICIENT UTILITY THEORY

&
EFFICIENT MARKET
HYPOTHEESIS

JOEL JOSE KUNNOOPARAMBIL

M.Com Finance & Taxation M4
 INTRODUCTION
• Standard economic theory is based on the belief that individuals behave in a rational
manner and that all existing information is embedded in the investment process.
• If this theory does not hold good, most of the theories in standard finance cannot be
validated.
The following popular theories in finance assume the same:

Modern Portfolio Theory of Harry Markowitz – Mean Variance

theory (1952)​
Capital Structure Irrelevance theory of Franco Modiglianni &
Merton H Miller (1958)​
Capital Asset Pricing Model by William Sharpe (1964)​
Efficient Market Hypothesis of Eugene Fama (1965)​
Arbitrage Pricing Theory Of Steve Alan Ross (1976)​

The basis of all these neo classical theories are that investors are rational.
 According to Modglliani & MIller, Rational Investors
are those people who always prefer more wealth to
less and will not take decisions based on emotions. To
put it differently, they are immune to cognitive and
emotional errors.
For Example:
RATIONAL • It is irrational to buy an Apple Mobile Phone by
paying 100000 when you can buy for Rs. 30000 a
INVESTOR Samsung Mobile having the same utility
• An individual could be exhibiting rational
behaviour if she is retiring early rather than staying
at the company and earning a pay check if she feels
the utility gained from retiring early exceeds that of
the pay check.
Assumptions of Standard Finance
Standard finance is built on five foundation blocks:

a. Investors are rational and are immune to cognitive

and emotional errors.
b. Investors construct portfolios according to Mean-
Variance Portfolio Theory. It mean that stocks
give the highest expected return at the lowest risk
will be included in the portfolio.
c. People save and spend as described by Standard
Life-Cycle Theory, where people find it easy to
identify and implement the right way to save and
spend. It means the people naturally follow the
right way to save and spend.
d. Markets are efficient.
e. Expected returns of investments are
calculated by Standard Asset Pricing Theory.
•The Standard life cycle hypothesis argued that people seek
to maintain roughly the same level of consumption throughout
their lifetimes by taking on debt or liquidating assets early and
late in life (when their income is low) and saving during their
prime earning years when their income is high.

•The Standard Asset Pricing Theory is as same as the

Capital Asset Pricing model. CAPM model is a financial
model that calculates the expected rate of return for an asset or
investment. CAPM does this by using the expected return on
both the market and a risk-free asset, and the asset's
correlation or sensitivity to the market (beta).

•The Modern Portfolio Theory (MPT) is a practical method

for selecting investments in order to maximize their overall
returns within an acceptable level of risk. This mathematical
framework is used to build a portfolio of investments that
maximize the amount of expected return for the collective
given level of risk.
 The concept of expected utility was first
posited by Daniel Bernoulli, who used it to solve the St.
Petersburg Paradox.
The theory states that when investors face various
investment alternatives under risky situations, they will
make rational choices by taking the weighted average of
each possible levels of utility. Thus, actions which give
EXPECTED the highest expected value will be chosen, where expected
value is found out by multiplying values of each possible
UTILITY outcomes (utilities) and probabilities of the same. To put
it simply:
THEORY 1. Investors find the statistical expected values of
various course of actions or Investments.
2. Under risky conditions, they take decisions after
comparing expected values of Investments or course
of actions.
3. They prefer investments with higher expected value
than investments with lower expected value.
 A. Expected Value
Expected value may be defined as the probability weighted average of utilities or
values of various outcomes. Here utility denotes the satisfaction level derived by the
investor from a particular outcome.
It calculated by taking the weighted average of all possible outcomes under given
circumstances.
For Example:
Ms. Maya has taken a lottery with 2% probability of winning Rs. 10000. The cost
of the lottery is Rs. 50. Expected value or pay off can be found out as follows.

Expected values = (10000 * 0.02) + (0*0.98)

= 20 + 0
=Rs. 20
 B. Modern Expected Utility Theory
Formulated in 1947 by Neumann and Oskar Morgenstern using expected utility theory.
The modern expected utility theory attempts to define and explain the rational behavior
of investors in the face of uncertainty. The theory states that:
1. Investors are rational
2. They are risk averse
3. They are able to deal with complex choices
4. They are value maximizers or utility maximizers

The axioms define a rational decision maker:

5. Completeness
6. Transitivity
7. Independence
8. Continuity
9. Frame Independence
10. Rational Preference
1. Completeness​: the state of being complete and entire
2. Transitivity​: it means that the preference of investors among different options are
open for transition.
3. Independence​: If an investors is indifferent between option A and option B, the
same will continue in all contexts.
4. Continuity​: continuity axiom states that investors can mix A & C in such a manner
that the individual investor is indifferent between mix of A&C and B.
5. Frame Independence​: it states that the investors cares only about the outcomes and
its probabilities
6. Rational Preference​: investors make rational choices to maximize their utility or
satisfaction
​
C. Expected Utility Theory and Risk Attitude

Modern expected utility theory not only predicts the expected utility values of games
and lotteries, it also categorizes investors into different groups. Individual investors
have different degrees of risk aversion. Based on the risk aversion or risk tolerance of
investors, they are classified into high risk averse investors, moderate risk averse
investors, risk seekers or risk lovers and risk neutrals investors.
Consider the example:
• Gamble cost = Rs.10000
• Outcomes :
If team A wins investor wins 20000 otherwise dead loss. It can be said a fair gamble
because the expected value of the game(0.5*20000 + 0.5 * 0) which is equal to the cost
of the gamble Rs.10000
•A risk averse investor will reject the gamble
because the utility of the gain is less the
disutility of the loss. When high risk averse
investors need high compensation risk
premiums for additional unit of risk,
moderate risk averse investors need
comparatively less compensation or risk
premium for taking additional risk. To put
it simply, risk averse investors derive less
utility from additional returns. In other word,
if the returns doubles, the utility of the risk
averse investor will not double (Diminishing
Marginal Utility).
U[E(P1)] < U(P1)
• For a risk seeker or risk lover, the utility
of the gain will be more than the
disutility of the loss. Therefore, he will
commit his funds in the gamble. The reason
is that risk seekers need only less
compensation or risk premium for taking
high risks. To put it simply, risk seekers
derive more utility from additional returns.
In other words, if the returns doubles the
utility of the risk seeker will be more than
double (Increasing Marginal Utility).
U[E(P1)] > U(P1)
•A risk neutral investor will be indifferent
on whether to undertake the gamble or
not. Risk neutral investors are only a
theoretical possibility as they do not need
any risk premium for taking risks.
Therefore, the utility curve of neutral
investors is a flat straight line. If the
returns double, the utility of the risk
neutral investor will also be doubled
(Constant Marginal Utility).
U[E(P1)] = U(P1)
D. Practical Applications of EUT

• Decision Making Under Uncertainty: Expected utility theory is used as a tool for
analyzing situations in which individuals must make a decision under uncertainty.

• Insurance Product Pricing: The expected utility concept is used to guide insurance
companies with regard to the pricing of insurance products.

• Capital Budgeting Decisions: Companies use expected monetary value criterion

while making long term investment decisions under uncertainty. If the expected
value is more than the initial investment, it is considered as a green signal to
purchase the asset and vice versa. Mathematicians extensively used Expected
Monetary Value (EMV) for the purpose of gamble assessment and lottery
assessment as well.
 The efficient market hypothesis (EMH), alternatively
known as the efficient market theory, is a hypothesis that
states that share prices reflect all available information
According to the EMH, stocks always trade at their fair
EFFICIENT value on exchanges, making it impossible for investors to
purchase undervalued stocks or sell stocks for inflated
MARKET prices.
HPOTHESIS Therefore, it should be impossible to outperform the
overall market through expert stock selection or market
timing, and the only way an investor can obtain higher
returns is by purchasing riskier investments.
 According to random walk theory, each security in the
market follows a random walk The theory states that
successive share price movements are independent of
previous prices but dependent on new pieces of information.
Therefore, it is impossible to predict stock prices. Louis
Bachelier (1900) and Maurice Kendall (1953) were the
scholars who identified the randomness of price behavior in
RANDOM the market. The arguments or assumptions of the theory are
briefly explained below:
WALK
• Stock price movements are Dependent on New
THEORY​ Information

• Market Participants have Full Knowledge of

Information

• Informational efficiency of the market

Assumptions of EMH (Features of Efficient Capital Market)
Efficient market hypothesis is based on the following assumptions:
• There is full disclosure and high degree of transparency in the market. It means that
governments, companies and regulators spread full information immediately without any
delay.

• There is free flow of information in the market and all market participants can easily access
the information. It means that information is costless.

• The market features perfect competition, i.e. there are large number of buyers and sellers in
the market.

• All investors are rational and they are capable of interpreting the information.

• There is no transaction cost.

• No single investor can influence the market unduly.

Criticisms of EMH (Features of Efficient Capital Market) :

• Information Asymmetry

• Random Stock price movements

• Abnormal Returns

• All investors are rational is myth

 MARKET A market anomaly is a price action that denies the
expected behaviour of the stock market. Some financial
ANOMALIES anomalies appear only once and disappear but others
repeat over a period of time.
1. Fundamental Anomalies:
The semi-strong form of efficiency states that current stock prices fully reflect all public
information. It says that no investor can earn abnormal returns using fundamental analysis.
Fundamental anomalies are related to stock valuation and it can generate abnormal returns.
A. Value Anomalies: There is a large body of evidence documented that investors
mistakenly overestimate the prospects of growth companies and underestimate value
companies (under-priced companies - market price is less than intrinsic value). In such
situations value strategies yield higher returns.
B. Low P/BV Anomalies: Many studies done by both academics and traders found that
the stocks with low P/BV ratio (price to book value) earn superior returns than stocks
with high P/BV ratio. This is known as low P/BV effect. These results directly question
the validity of market efficiency.
C. Low P/E Anomalies: Many studies done by both academics and traders found that the
stocks with low P/E ratio earn superior returns than stocks with high P/ E ratio. This is
known as low P/E effect. These results directly question the validity of market
efficiency.
d. Dividend Yield Anomalies: Many studies done by both academics and traders found that
the stocks with high dividend yield earn superior returns than stocks with low dividend yield.​

e. Small-firm Anomalies: Some studies suggest that investors in small firms enjoy
superior returns compared to investors in large firms. This is known as small firm effect.
This may be due to less information available on small companies.​
2. Technical Anomalies
The weak form of efficiency states that current stock prices fully reflect all historic information.
It says that no investor can earn abnormal returns using technical analysis. However evidence
suggests that active strategies (applying trading rule) developed based on past trends can be
used to earn abnormal returns. For example, yesterday's top performers become tomorrow's
underperformers, and vice versa is a trend.

3. Seasonal Anomalies (Calendar Anomalies)

It comes during a particular period of a year.
a. The Weekend Effect: Many studies show that Monday's return (Friday-Monday return) is
lower than the returns of other days. The reason is that stock prices tend to rise on Fridays
(Weekend) and are traded on Mondays at reduced prices. This trend is called weekend effect.
If the market is efficient, this is not possible.
b. The January Effect: Some of the studies show that the returns of January month are
consistently higher than other months. This evidence is against the premise of market
efficiency.