Efficient Market Theory

Efficient Market TheoryCompiled by: CA Sapna Jain

10/19/20141The efficient market hypothesis is a central idea of a modern finance that has profound implications. An understanding of the efficient market hypothesis will help to ask the right questions and save from a lot of confusion that dominates popular thinking in finance.

10/19/20142DefinitionsMarket Efficiency: The expectations of the investors regarding the future cash flows are translated or reflected on the share prices. The accuracy and the quickness in which the market translates the expectation into prices are termed as market efficiency. These are of two types:(1) Operational Efficiency: It can be measured by factors like time taken to execute an order and the number of bad deliveries. Investor are concerned with this type of efficiency but EMH does not.(2) Informational Efficiency: It is a measure of the swiftness or the markets reaction to new information like economic reports, company analysis, political statements & new industrial policies.

10/19/20143DefinitionsLiquidity Traders: These traders investments and resale of shares depends upon their individual fortune. Liquidity traders sell their shares to pay their bills. They dont investigate before they invest.Information Traders: These investors analyze before any buy or sell. They estimate the intrinsic value of shares. The deviation between the intrinsic value and the market value makes them enter the market. They sell if the market is higher than the intrinsic value and vice-versa. The buying and selling of the shares through the demand and supply forces bring the market price back to its intrinsic value.

10/19/20144Random-Walk TheoryAn efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic value. Note: Market efficiency does not imply that the market price equals intrinsic value at every point in time. All that it says is that the errors in the market prices are unbiased. This means that the price can deviate from the intrinsic value but the deviations are random and correlated with any observable variable. If the deviations of market price from intrinsic value are random, it is not possible to consistently identify over or under-valued securities.

10/19/20145No Bargain Market efficiency is defined in relation to information that is reflected in security prices. In an efficient market, all the relevant information is reflected in the current stock price. Information cannot be used to obtain excess return. The information has already been taken into account and absorbed in the prices. In other words, all prices are correctly stated and there are no bargains in the stock market.

10/19/20146Requirements for efficient marketPrices must be efficient so that new inventions and better products will cause a firms securities prices to rise and motivate investors to supply capital to the firm (i.e., buy its stock).Information must be discussed freely and quickly across the nations so all investors can react to new information.Transactions costs such as sales commissions on securities are ignored.Taxes are assumed to have no noticeable effect on investment policy.Every investor is allowed to borrow or lend at the same rate.Investors must be rational and able to recognize efficient assets and that they will want to invest money where it is needed most (i.e., in the assets with relatively high returns).

10/19/20147

Forms of EMH

Strongly efficient market All information is reflected on prices. Semi Strong efficient market All public information is reflected on security prices. Weakly efficient market All historical information is reflected on security prices. 10/19/20148Weak Form of EMH

The week form of market holds that present stock market prices reflect all known information with respect to past stock prices, trends, and volumes. This form of theory is just the opposite of the technical analysis because according to it, the sequence of prices occurring historically does not have any value for predicting the future stocks prices. The technical analysts rely completely on charts and past behavior of prices of stocks.

10/19/20149Weak Form of EMH

In the week form of the market no investor can use any information of the past to earn a return of portfolio which is in excess of the portfolios risk. This means that the investor who develops the strategy based on past prices and chooses his portfolio on that basis cannot continuously outperform another investor who buys and holds his investments over a long term period.

10/19/201410Weak Form of EMH

Weak form takes only the average change of todays prices and states that they are independent of all prior prices. The evidence supporting the random walk behavior also supports the EMH and states that the large price changes are followed by larger price changes, but they do not change in any direction which can be predicated. This observation in a way violates the random walk behavior that it does not violate the weak form of the market efficiency. Researchers have studied that the evidence which supports the efficient market behavior is based on the random walk behavior of security prices but there is evidence which contradicts the random walk hypothesis. This does not mean that it contradicts the efficient market hypothesis also.

10/19/201411Weak Form of EMH

Three types of tests have been commonly employed to empirically verify the weak-form efficient market hypothesis: (a) Serial correlation tests; (b) Runs tests(c) Filter rules tests.

10/19/201412

Weak Form of EMH Serial Correlation Test:

Serial Correlation is said to measure the association of a series of numbers which are separated by some constant time period. One way to test for randomness in stock price changes is to look at their serial correlations. Is the price change in one period correlated with the price change in some other period? If such auto-correlations are negligible, the price changes are considered to be serially independent. Numerous serial correlation studies, employing different stocks, different time-lags, and different time-periods, have been conducted to detect serial correlations. In general, these studies have failed to discover any significant serial correlations.10/19/201413Serial Correlation Test

Moore measured correlation of the price change of one week with the price change of the next week. His research showed average serial correlation of -0.06 which indicated a very low tendency of security price to reverse dates. This means that a price rise did not show the tendency to follow the price fall or vice versa. Fama also tested the serial correlation of daily price changes in 1965. He studied the correlation for 30 firms which composed of the Dow Jones Industrial Averages for five years before 1962. His study showed an average correlation of -0.03. This correlation was also weak because it was not very far away from zero.10/19/201414Weak Form of EMH Run Test

Run Test was also made by Fama to find out it price changes were likely to be followed by further price changes of the same sign. Run Test ignored the absolute values of numbers in the series and took into the research only the positive and negative signs. Given a series of stock price changes, each price (+) if it represents an increase or a minus (-) if it represents a decrease. Run test is used to find out whether the series of prices movement have occurred by chance. A run is uninterrupted sequence of the same observation.cont..

10/19/201415Weak Form of EMH Run Test

For Example: If a coin is tossed the following sequence my occur: HHTTTHHHTHHHere occurrence of HH is a run and TT is another run. When the sequence of the observations change we count it as a runRun Test Z = R X R = No. of runs X = 2n1 n2 + 1 n1 + n2 2= 2n1 n2 (2n1 n2 - n1 - n2 ) (n1 + n2 )2 (n1 + n2 - 1 ) n1 + n2 = No. of observations in each category Z = standard normal variate

10/19/201416Weak Form of EMH Run Test

Ques: Reliance Petroleum stock prices are given below , apply run test.

DatePriceRunDatePriceRunDatePriceRunSept. 2021 2223242829Oct. 145643.0543.4041.7542.6543.6043.0543.4046.8046.6047.5047.40781112131415192021252652.1552.5053.4557.5557.4555.9054.1554.7058.9560.3059.6558.65272829Nov. 12345791011 56.8053.5051.5048.4052.3056.0555.1556.4057.1557.2557.5556.7510/19/201417Weak Form of EMH Filter rule

It is a technique for filtering out the important information from the unimportant. Alexander and Fama and Blume took the idea that price and volume data are supposed to tell the entire story we need to know to identify the important action in stock prices. They applied filter rules to see how well price changes pick up both trends and reverses which chartists claim their charts do. If a stock moves up X%, buy it and hold it long; if it then reverses itself by the same percentage, sell it and take a short position in it. When the stock reverses itself again by X% cover the short position and buy the stock long. The size of the filter varied from 0.5 to 50%.

10/19/201418Weak Form of EMH Filter Rule

Example: Let filter in XY Ltd is 10%. The Price fluctuate between Rs. 20 to 30. Let starting point to be 20. When there is an increase in the price to Rs. 22 i.e. 10% rise, one has to buy it. The rally may continue upto Rs. 30 and decline. If the price falls the sell signal is given at 27 Rs. i.e. 10% of Rs. 30 and the trader can take up the short position till it reaches its low level. When there is a rise in price the same exercises have to be followed. 10/19/201419Semi Strong Form of EMH The semi strong form of the EMH centers on how rapidly and efficiently market prices adjust to new publicly available information. In this state, the market reflects even those forms of information which may be concerning the announcement of a firms most recent earnings forecast and adjustments which will have taken place in the prices of security.The investor in the semi-strong form of the market will find it impossible to earn a return on the portfolio which is based on the publicly available information in excess of the return which may be said to be commensurate with the portfolio risk.

10/19/201420Semi Strong Form of EMH Many empirical studies have been made on the semi-strong form of the efficient market hypothesis to study the reaction of security prices to various types of information around the announcement time of the information.Two studies commonly employed to test semi-strong form efficient market are:(1) Event study (2) Portfolio study.

10/19/201421Semi Strong Form of EMH Event Study: It examines the market reactions to and the excess market returns around a specific information event like acquisition announcement or stock split. The key steps involved in an event study are as follows:

Identify the event to be studied and pinpoint the date on which the event was announced.Collect returns data around the announcement date. In this context two issues have to be resolved: What should be the period for calculating returns weekly, daily, or some other interval? For how many periods should returns be calculated before and after the announcement date? Cont

10/19/201422Event Study Cont(3) Calculate the excess returns, by period, around the announcement date for each firm in the sample. The excess return is calculated by making adjustment for market performance and risk.(4) Compute the average and the standard error of excess returns across all firms Assess whether the excess returns around the announcement date are different from zero. (5) To determine whether the excess returns around the announcement date are different from zero, estimate the T statistic for each day.

10/19/201423Semi Strong Form of EMH Portfolio study: In a portfolio study, a portfolio of stocks having the observable characteristic (low price earnings ratio or whatever) is created and tracked over time see whether it earns superior risk-adjusted returns. Steps involved in a portfolio study are as follows:(1) Define the variable (characteristic) on which firms will be classified. The proposed investment strategy spells out the relevant variable. The variable must be observable, but not necessarily numerical. Cont..

10/19/201424Portfolio Study Cont (2) Classify firms into portfolios based upon the magnitude of the variable.(3) Collect data on the variable for every firm in the defined universe at the beginning of the period and use that information for classifying firms into different portfolios.(4) Compute the returns for each portfolio on the returns for each firm in each portfolio for the testing period and calculate the return for each portfolio, assuming that the stocks included in the portfolio are equally weighted.(5) Calculate the excess returns for each portfolio. The calculation of excess returns earned by a portfolio calls for estimating the portfolio beta and determining the excess returns. Cont..

10/19/201425Portfolio Study Cont (6) Assess whether the average excess returns are different across the portfolios. Several statistical tests are available to test whether the average excess returns differ across these portfolios. Some of these tests are parametric and some nonparametric. Many portfolio studies suggest that it is not possible to earn superior risk adjusted returns by trading on some observable characteristics. However, several portfolio studies have documented inefficiencies and anomalies.

10/19/201426Strong Form of EMH This market hypothesis holds that all available information, public or private, is reflected in the stock prices. The strong form is concerned with whether or not certain individuals or groups of individuals possess inside information which can be used to make above average profits. If the strong form of the efficient capital market hypothesis holds, then and day is as good as any other day to buy any stock. This the most extreme form of the EMH. Most of the research work has indicated that the efficient market hypothesis in the strongest form does not hold good.

10/19/201427Strong Form of EMH Empirical Evidence: Many of the tests of the strong form of EMH deal with mutual fund performances. Financial analysts have studied the risk adjusted rates of return from hundreds of mutual funds and found that the professionally managed funds are not able to out perform the buy hold strategy. Jensen had studied 115 funds over a decade. He concluded that even though the analysts are well endowed with wide ranging contacts and associations in both the business and financial committees, they are unable to forecast returns accurately enough to recover the research and transaction costs. He holds this, as a striking piece of evidence for the strong form of EMH

10/19/201428Market Efficiency and AnomaliesAnomalies are situations that appear to violate the traditional view of market efficiency, suggesting that it may be possible for careful investors to earn abnormal returns. Some stock market anomalies are: (1) Low Price-Earnings Ratio: Stock that are selling at price earnings ratios that are low relative to the market.(2) Low Price-Sales Ratio: Stocks that have price-to-sales ratios that are lower competed with other stocks in the same industry or with the overall market.(3) Low Price-to Book value Ratio: Stocks whose stock prices are less that their respective book values.

Cont

10/19/201429Market Efficiency and Anomalies(4) High Dividend Yield: Stocks that pay high dividends relative to their respective share prices.(5) Small companies: Stock of companies whose market capitalization is less than 100 million.(6) Neglected Stocks: Stocks followed by only a few analysts and/or stocks with low percentages of institutional ownership.(7) Stocks with High Relative Strength: Stocks whose prices have risen faster relative to the overall market.(8) January Effect: Stock do better during January than during any other month of the year.(9) Day of the Week: Stock of poorer during Monday than during other days of the week.

10/19/201430Thank You

10/19/201431