Efficient Capital Markets

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Our presentation on

Efficient Capital Markets By

Name ID Batch

Md. Ashikollah 51427032 27th

Mohiuddin Mohammed Abdul Ahad 51427070 27th

A.B.M Salahuddin 51324067 24th

Efficient Capital Market

Two forms of market efficiencyInformational efficiency – the subject of this chapterTransactional efficiency – minimize cost

Economies of scaleEconomies of scope

In an efficient capital market, security pricesReflect all available informationAdjust rapidly to the arrival of new information.

Whether markets are efficient has been extensively researched and remains controversial

Why Should Capital MarketsBe Efficient?

A large number of competing profit-maximizing participants analyze and value securities, each independently of the others

New information regarding securities comes to the market in a random fashion

Profit-maximizing investors rapidly adjust (in an unbiased fashion) security prices to reflect the impact of new information

Finally, In an efficient market, the expected returns embedded in the current price of a security should accurately reflect its risk

Efficient Market Hypotheses (EMH) Basically, Efficient market hypothesis of investment gives the

idea that the market cannot be beaten as it incorporates all important determinative information into current share prices.

Stocks trade at the fairest. To gain higher returns, investments is made through purely

speculative that pose substantial risk. Efficient Market Hypothesis (EMH) is divided into three sub-

hypotheses depending on the information set involved Weak-form efficient Semi-strong form efficient Strong-form efficient

Weak-Form EMH

The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates.

Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid. 

Weak Form TestsStatistical Tests for Independence - 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).

Trading Tests -  The rules that traders follow are invalid. An example of a trading test would be the filter rule, which shows that after transaction costs, an investor cannot earn an abnormal return.

Semistrong-Form EMHThe 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.

Semi-strong Form TestsEvent Tests-An event test analyzes the security both

before and after an event, such as earnings. The idea behind the event test is that an investor will not be able to bring in an above average return by trading on an event.

Regression/Time Series Tests -Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.

Strong-Form EMH

Stock prices fully reflect all information from public and private sources

This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return

This assumes perfect markets in which all information is cost-free and available to everyone at the same time

Strong-Form TestsGiven that the strong-form implies that the market is reflective

of all information, both public and private, the tests for the strong-form center around groups of investors with excess information. These investors are as follows:

Insiders  Exchange Specialists Analysts Institutional money managers

Insiders - Insiders to a company, such as senior managers, have access to inside information. SEC regulations forbid insiders for using this information to achieve abnormal returns.

Exchange Specialists - An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that exchange specialists can achieve above average returns with this specific order information.

Analysts - The equity analyst has been an interesting test. It analyzes whether an analyst's opinion can help an investor achieve above average returns. Analysts do typically cause movements in the equities they focus on.

Institutional money managers - Institutional money managers, working for mutual funds, pensions and other types of institutional accounts, have been found to have typically not perform above the overall market benchmark on a consistent basis.

Behavioral FinanceIt is concerned with the analysis of various

psychological traits of individuals and how these traits affect the manner in which they act as investors, analysts, and portfolio managers

It is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make

irrational financial decision.

Implications of Efficient Capital Markets

Capital markets are efficient as related to numerous sets of information that rapidly adjust the stock prices.

There are substantial instances where the market fails to rapidly adjust to public information

Efficient Markets and Technical Analysis

Assumptions of technical analysis directly oppose the notion of efficient markets

Technicians believe that new information is not immediately available to everyone, but disseminated from the informed professional first to the aggressive investing public and then to the masses

Efficient Markets and Technical Analysis

Technicians also believe that investors do not analyze information and act immediately - it takes time

Therefore, stock prices move to a new equilibrium after the release of new information in a gradual manner, causing trends in stock price movements that continue for periods

Efficient Markets and Technical Analysis

Technical analysts develop systems to detect movement to a new equilibrium (breakout) and trade based on that

Which Contradicts rapid price adjustments indicated by the EMH.

If the capital market is weak-form efficient, a trading system that depends on past trading data can have no value.

Efficient Markets and Fundamental Analysis

Fundamental analysts believe that there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities and these values depend on underlying economic factors

Investors should determine the intrinsic value of an investment at a point in time and compare it to the market price

Efficient Markets and Fundamental Analysis

By doing a superior job of estimating intrinsic value, superior market timing decisions can be made and generated above-average returns.

This involves-

1.Aggregate market analysis,

2.Industry analysis,

3.Company analysis, and

4.Portfolio management

Aggregate Market Analysis with Efficient Capital Markets

EMH implies that examining only past economic events is not likely to lead to outperforming a buy-and-hold policy because the market adjusts rapidly to known economic events

Merely using historical data to estimate future values is not sufficient

So we must estimate the relevant variables that cause long-run movements

Industry and Company Analysis with Efficient Capital Markets

Wide distribution of returns from different industries and companies justifies industry and company analysis

We must understand the variables that effect rates of return and do a superior job of estimating future values of these relevant valuation variables, not just look at past data

Efficient Markets and Portfolio Management

Portfolio Managers with Superior Analysts: Concentrate efforts in mid-cap stocks that do

not receive the attention given by institutional portfolio managers to the top-tier stocks.

The market for these neglected stocks may be less efficient than the market for large well-known stocks

Efficient Markets and Portfolio Management

Portfolio Managers without Superior AnalystsDetermine and quantify client's risk preferencesConstruct the appropriate portfolioDiversify completely on a global basis to

eliminate all unsystematic riskMaintain the desired risk level by rebalancing

the portfolio whenever necessaryMinimize total transaction costs

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