Chapter 8

Random Walks and Efficient Markets

Learning GoalsWhat is Random walkWhat is Efficient Market Hypothesis

(EMH)Differentiate between the levels of

Market efficiency.

IntroductionEfficient Market Hypothesis (EMH), formally

presented by Eugene Fama (1970), asserts that financial asset prices fully reflect all available, relevant information.

Implicit in this assertion is the idea that financial asset prices reflect all relevant historical and current information, and that they incorporate every piece of forecastable information into unbiased forecast of future prices.

EMH conclude that:Securities are rarely, if ever, substantially

mispriced in the marketplaceNo security analysis, however detailed, is

capable of identifying mispriced securities with a frequency greater than that, which might be expected by random chance alone.

Random Walks HypothesisRandom Walk: the theory that stock price

movements are unpredictable, so there is no way to know where prices are headedStudies of stock price movements indicate that

they do not move in neat patterns

This could be an indication that markets are highly efficient and respond quickly to changes in the current situation

Random Walks HypothesisRandom Walk: the theory that stock price

movements are unpredictable, so there is no way to know where prices are headedStudies of stock price movements indicate that

they do not move in neat patterns

This could be an indication that markets are highly efficient and respond quickly to changes in the current situation

Efficient MarketsEfficient Market: a market in which

securities reflect all possible information quickly and accurately

Efficient Market Hypothesis: markets have a large number of knowledgeable investors who react quickly to new information, causing securities prices to adjust quickly and accurately

To have an efficient market, you must have:Many knowledgeable investors active in

analyzing and trading stocksInformation is widely available to all investors

and is free/easy to obtainEvents, such as labor strikes or accidents, tend

to happen randomlyInvestors react quickly and accurately to new

information, causing prices to adjust

Levels of Efficient MarketsWeak Form

Past data on stock prices are of no use in predicting future stock price changes

Everything is randomShould simply use a “buy-and-hold” strategy

Semi-strong FormAbnormally large profits cannot be consistently

earned using public informationAny price anomalies are quickly found out and

the stock market adjusts

Strong FormThere is no information, public or private, that

allows investors to consistently earn abnormally high returns

Version of theory Information impounded in prices

Weak form

Semi- strong form

Strong form

Past prices of securities

All Publicly available information

All public and private information

Behavioral FinanceOften a seeming refutation of the efficient

market theory may instead be a refutation of the asset-pricing model (that is Beta the only measure of risk and return).

Behavioral finance theorist found that several unexplainable anomalies have been identified that gives an impact on security’s return which is call market anomalies

Market AnomaliesP/E Effect

Uses P/E ratio to value stocksLow P/E stocks may outperform high P/E

stocks, even after adjusting for risk

Small-Firm EffectSize of a firm impacts stock returnsSmall firms may offer higher returns than

larger firms, even after adjusting for riskNeglected-firm effect

The tendency of investment in stock of less well-known firm to generate abnormal return

Book-to-market effectThe tendency for investment in shares of firms with

high ratios of book value to market value to generate abnormal returns.

Reversal effectThe tendency of poorly performing stocks and well-

performing stocks in one period to experience reversals in the following period.

Calendar EffectsStocks returns may be closely tied to the time of

year or time of weekQuestionable if really provide opportunityExamples: January effect, weekend effect

Earnings AnnouncementsStock price adjustments may continue after

earnings adjustments have been announcedUnusually good quarterly earnings reports may

signal buying opportunity