Efficient Market Hypothesis

Efficient Market HypothesisEfficient Market Hypothesis (EMH) asserts that

financial markets are “efficient” denoting that the

prices of traded assets already reflect all known

information.

All relevant information is full and immediately

reflected in a security’s market price.

Only new information will affect the price of the

asset

• Fundamental analysis seeks to evaluate intrinsic value of the securities.

• Technical analysis believes that the past behavior of stock prices gives an indication of the future behavior.

• The basic assumption in technical analysis is that stock price movement is quite orderly and not random.

• New theory questions this assumption.• Share price movements are random. It is known

as Random Walk Theory.• Because of its principal contention that share price

movements represent a random walk rather than an orderly movement.

Efficient Market Hypothesis• Financial markets are efficient :which means that

the prices of traded assets already reflect all known information. The prices of the asset reflect the collective beliefs all the investors.

• Efficient Market Hypothesis implies that it is not possible to consistently outperform the market. Only new information will affect the price of assets.

• Information or news in EMH is defined as anything that may affect asset prices. Prices react to information . Flow of information is random. Therefore price changes are random.

• Louis Bachelier in the early 1900 stated that stock prices are governed by a random walk.

• The random walk theory arrests that price movements will not follow any patterns or trends and that past price movement can’t be used to predict future price movements.

• Engece Fama proposed Efficient Market Hypothesis first.

• This Hypothesis states that all relevant information is fully and immediately reflected in a security’s market price

“Efficient Market” as a market where there are a large of rational, profit-maximizes who are actively competing with each other and who are trying to predict future market values of individual securities and where important current information is almost feely available to all participants.

Efficient Market:3 types of market efficiently used to describe financial markets.

There are three types of market efficiency:

- when prices are determined in a way that equates the marginal rates of return (adjusted for risk) for all producers and savers, market is said to be allocationally efficient;

- when the cost of transfering funds is “reasonable”, market is said to be operationally efficient;

- when prices fully reflect all available information, market is said to be informationally efficient.

Allocational efficiency:• A financial system exhibits allocated efficiency if it allocates

capital to its highest and best use. Ex: stock market investors shun security offers from firms in declining Industries.

Operational efficiency:• Refers to how large an influence transaction costs and other

market frictions have on the operation of a market.

Informational efficiency:• Refers to whether prices reflect “true value”. In a market

exhibiting informational efficiency, asset prices incorporate all relevant information fully and instantaneously. Ex: A takeover B Stock price of A increase immediately to reflect the per share bid premium

• Market efficiency refers to a condition in which current prices reflect all the publicly available information about a security.

• Competition will drive all information into the price quickly.

• In financial market maximum price that investors are willing to pay for a financial asset is actually the current value of future cash payments that discounted for uncertainty in cash flow project.

• Market efficiency means that the prices are correct. They fully reflect all available information.

• In efficient market prices react to new information quickly and to the right extent. There is no free lunch in an efficient market. Only way you can get higher returns is by taking more on more risk.

The value of an efficient market

• To encourage share buying Accurate pricing is required if individuals are to be encouraged to invest in cos. Investors need the assurance that they are paying a fair price for their acquisition of shares and that they will be able to sell their holdings at a fair price- that the market is efficient.

• To give correct signals to co managersMax. of SH wealth is the goal of mgrs. Mgrs take decisions only when they know that SH wealth is maximizing and is incorporated in the share price. This is possible only if market is efficient.

• To help allocate resourcesIf a badly run co in a declining industry has shares that r highly valued because the stock market is not pricing them correctly, then this co will be able to issue new capital by issuing shares. It would not become optimal allocation of resources.

Random Walk Theory • It assert that prices have no memory. Therefore past

and present prices can’t be used to predict future prices(as implied in technical analysis). Prices move at random , since new information is random,& adjust to new inf. As it becomes available. The adjustment to this information is so fast that it is impossible to profit from it. News & events are also random & trying to predict these (fundamental analysis) is also useless.

• Types of market efficiency:

• Weak-form efficiency: the information set includes only the history of prices or returns themselves. A capital market is said to satisfy weak-form efficiency if it fully incorporate the information in past stock prices.

• Semistrong-form efficiency: the information set includes all information known to all market participants (publicly available information). A market is semi-stron efficiemt if prices reflect all publicly available information.

• : the information set includes all information knownStrong-form efficiency to any market participant (private information). This form says that anythin that is pertinent to the value of the stock and that is known to at least one investor is, in fact fully incorporated into the stock value.

Empirical tests of EMH

• Weak form efficiency: prices incorporate information about past prices

• Semi-strong form: incorporate all publicly available information

• Strong form: all information, including inside information

Weak Form Market Efficiency• 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.

• If the weak form of market efficiency holds, then technical analysis is of no value.

• Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.

• Most research supports the notion that the markets are weak form efficient.

• Autocorrelation test investigates whether the returns are statistically independent of each other i.e. can past stock return data predict future stock data.

• Filter rule is a trading rule regarding the actions to be taken when shares rise or fall in value by X%. Filter rules should not work if markets are weak form efficient.

• Run test

Semi-Strong Form Market Efficiency• The semi-strong form says that prices fully reflect all

publicly available information and expectations about the future.

• Stock price moments during public announcement and after a public announcement is called Event studies.

• Stock split or announcement of corporate earnings.• 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.

Tests of the Semi-strong Form

• Event Studies– Stock splits– Earnings announcements– Analysts recommendations

• Cross-Sectional Return Prediction– Firm size– BV/MV– P/E

Strong Form Market Efficiency• Security Prices reflect all information—public and

private.• Strong form efficiency incorporates weak and semi-

strong form efficiency.• Strong form efficiency says that anything pertinent to

the stock and known to at least one investor is already incorporated into the security’s price.

• Even the knowledge of material, non-public information cannot be used to earn superior results.

• Most studies have found that the markets are not efficient in this sense

Tests of the Strong Form

• Corporate Insiders.• Specialists.• Mutual Funds.• Studies have shown that insiders and

specialists often earn excessive profits, but mutual funds (and other professionally managed funds) do not.

• In fact, in most years, around 85% of all mutual funds underperform the market.

Relationship among Three Different Information Sets

All informationrelevant to a stock

Information setof publicly available

information

Informationset of

past prices

Anomalies

• Anomalies are unexplained empirical results that contradict the EMH:– The Size effect.– The “Incredible” January Effect.– P/E Effect.– Day of the Week (Monday Effect).

The Size Effect

• Beginning in the early 1980’s a number of studies found that the stocks of small firms typically outperform (on a risk-adjusted basis) the stocks of large firms.

• This is even true among the large-capitalization stocks within the S&P 500. The smaller (but still large) stocks tend to outperform the really large ones.

The “Incredible” January Effect

• Stock returns appear to be higher in January than in other months of the year.

• This may be related to the size effect since it is mostly small firms that outperform in January.

• It may also be related to end of year tax selling.

The P/E Effect

• It has been found that portfolios of “low P/E” stocks generally outperform portfolios of “high P/E” stocks.

• This may be related to the size effect since there is a high correlation between the stock price and the P/E.

• It may be that buying low P/E stocks is essentially the same as buying small company stocks.

The Day of the Week Effect

• Based on daily stock prices from 1963 to 1985 Keim found that returns are higher on Fridays and lower on Mondays than should be expected.

• This is partly due to the fact that Monday returns actually reflect the entire Friday close to Monday close time period (weekend plus Monday), rather than just one day.

• Moreover, after the stock market crash in 1987, this effect disappeared completely and Monday became the best performing day of the week between 1989 and 1998.

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.

• Ultimately, most believe that the market is very efficient, though not perfectly efficient. It is unlikely that any system of analysis could consistently and significantly beat the market (adjusted for costs and risk) over the long run.

Random Walk Theory and Efficient Market Hypothesis (EMH)