Capital Market EfficiencyCapital Market Efficiency

What ifWhat if

What if you have figured the What if you have figured the following:following:– Buy if out of the 20 trading days for the Buy if out of the 20 trading days for the

past month, stock XYZ has been rising for past month, stock XYZ has been rising for more than 2/3 of the times.more than 2/3 of the times.

– Sell if out of the 20 trading days for the Sell if out of the 20 trading days for the past month, stock XYZ has been falling past month, stock XYZ has been falling for more than 2/3 of the times.for more than 2/3 of the times.

– Follow this rule strictly, return is Follow this rule strictly, return is “abnormally high”.“abnormally high”.

Stock Price Reflects InformationStock Price Reflects InformationIf you have spotted XYZ’s stock pattern that If you have spotted XYZ’s stock pattern that guarantee you pure profit, what should you do?guarantee you pure profit, what should you do?You should definitely exploit it. (How? Borrow as much You should definitely exploit it. (How? Borrow as much as you can to invest.)as you can to invest.)The process of exploiting it actually makes the The process of exploiting it actually makes the opportunity vanishes because:opportunity vanishes because:You would bid up XYZ stock price when you think it is You would bid up XYZ stock price when you think it is hot. Higher prices mean lower expected return.hot. Higher prices mean lower expected return.You would also likely bid down XYZ stock price when You would also likely bid down XYZ stock price when you think it is cold. Lower prices mean higher you think it is cold. Lower prices mean higher expected return.expected return.In short, the fact that you have figured out a stock In short, the fact that you have figured out a stock price movement is very likely to be reflected by the price movement is very likely to be reflected by the stock price. stock price. The more greedy (which is rational, more precisely, is The more greedy (which is rational, more precisely, is the higher the ability for you to raise fund) you are, the higher the ability for you to raise fund) you are, the faster your pattern will be eliminated.the faster your pattern will be eliminated.

Price Movement PatternPrice Movement PatternS

tock

Pri

ce

Time

Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.

If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.

Sell

Sell

Buy

Buy

The ArmyThe ArmyImagine not only you, there exists an “army” of Imagine not only you, there exists an “army” of intelligent, well-informed security analysts, intelligent, well-informed security analysts, arbitragers, traders, who literally spend their lives arbitragers, traders, who literally spend their lives hunting for securities which are mis-priced or hunting for securities which are mis-priced or following a price moving pattern based on currently following a price moving pattern based on currently available information. available information. They have high-tech computers, subscription to They have high-tech computers, subscription to professional database, up-to-date information on professional database, up-to-date information on thousands of firms, state-of-the-art analytical thousands of firms, state-of-the-art analytical technique, etc.technique, etc.These people can assess, assimilate and act on These people can assess, assimilate and act on information, very quickly.information, very quickly.In their intense search for mis-priced securities, In their intense search for mis-priced securities, professional investors may “police” the market so professional investors may “police” the market so efficiently that they drive the prices of all assets to efficiently that they drive the prices of all assets to fully reflect all available information.fully reflect all available information.

ImplicationsImplicationsCompetition for finding mispriced Competition for finding mispriced securities is fierce.securities is fierce.Such competition always kills the “sure-Such competition always kills the “sure-profit” pattern because were there one, it profit” pattern because were there one, it would have been exploited by someone would have been exploited by someone who first spotted it. Thus, roughly who first spotted it. Thus, roughly speaking, “no arbitrage” should hold. speaking, “no arbitrage” should hold. The implications:The implications:– stock prices should have reflected all stock prices should have reflected all

available information.available information.– stock prices should be unpredictable.stock prices should be unpredictable.

UnpredictabilityUnpredictabilityPrices are unpredictable in the sense Prices are unpredictable in the sense that stock prices should have that stock prices should have reflected “all available information”.reflected “all available information”.

Thus if stock prices change, it should Thus if stock prices change, it should be reacting only to “new information”.be reacting only to “new information”.

The fact that information is new The fact that information is new means stock prices are unpredictable.means stock prices are unpredictable.

RANDOM WALK

• Maurice Kendall found that stock prices followed a random walk, implying that successive price changes are independent of one another.

• A number of researchers have employed ingenious methods to test the randomness of stock price behaviour.

• Academic researchers concluded that the randomness of stock prices was the result of an efficient market.

Market EfficiencyMarket EfficiencyIf all past information is incorporated in the If all past information is incorporated in the price then it should be impossible to price then it should be impossible to consistently beat the market using technical consistently beat the market using technical analysis and the like.analysis and the like.

Definition 1:Definition 1:– Eugene Fama defined Market Efficiency as the state Eugene Fama defined Market Efficiency as the state

where "security prices reflect all available where "security prices reflect all available information.“information.“

Definition 2:Definition 2:– Financial markets are efficient if Financial markets are efficient if currentcurrent asset prices asset prices

fully reflect all fully reflect all currentlycurrently available relevant available relevant information.information.

Meaning of EMHMeaning of EMHEfficient Market Hypothesis (EMH) believes Efficient Market Hypothesis (EMH) believes that markets are efficient and every kind of that markets are efficient and every kind of price sensitive information is available to price sensitive information is available to the investors, who are capable to interpret if the investors, who are capable to interpret if efficiency. It is bases on theefficiency. It is bases on thefollowing;following;– Full disclosure and transparencyFull disclosure and transparency– Free flow of informationFree flow of information– Large number of buyersLarge number of buyers– Price reflect information effectPrice reflect information effect– No one influence the market undulyNo one influence the market unduly..

Fama Formulation of the Efficient Fama Formulation of the Efficient Market ModelMarket Model

E(PE(Pj t + i/ ффtt) = [1 + E(r) = [1 + E(rj t + i/ ффtt)]P)]Pjt

E(PE(Pj t + i/ ффtt) = Expected end of the period price of ) = Expected end of the period price of security j given the information beginning of the security j given the information beginning of the period.period.

E(rE(rj t + i/ ффtt) = Expected return over the forthcoming ) = Expected return over the forthcoming period on the basis of information available in the period on the basis of information available in the beginning of the year.beginning of the year.

PPjt = Price of the security j at the beginning of the period.

Subsets of Available InformationSubsets of Available InformationFor a Given StockFor a Given Stock

Information in past stock prices

All Public Information

All Available Information including inside or private information

3 Forms of Market Efficiency 3 Forms of Market Efficiency HypothesisHypothesis

Information in past stock prices

All Public Information

All Available Information including inside or private information

Since we are more interested in how efficient is the capital market, we define the following 3 forms of market efficiency hypothesis:

“A market is efficient if it reflects ALL available information”

[1] Strong-form

- ALL available info

[2] Semi-strong form

- ALL available info

[3] Weak-form

- ALL available info

3 Forms of Market Efficiency Hypothesis3 Forms of Market Efficiency Hypothesis

Weak-formWeak-form““Stock prices are assumed to reflect any information that may be contained in the past Stock prices are assumed to reflect any information that may be contained in the past history of the stock price itself.”history of the stock price itself.”For example, suppose there exists a seasonal pattern in stock prices such that stock For example, suppose there exists a seasonal pattern in stock prices such that stock prices fall on the last trading day of the year and then rise on the first trading day of the prices fall on the last trading day of the year and then rise on the first trading day of the following year. Under the weak-form of the hypothesis, the market will come to following year. Under the weak-form of the hypothesis, the market will come to recognize this and price the phenomenon away.recognize this and price the phenomenon away.

Semi-strong-formSemi-strong-form““Stock prices are assumed to reflect any information that is publicly available.”Stock prices are assumed to reflect any information that is publicly available.”These include information on the stock price series, as well as information in the firm’s These include information on the stock price series, as well as information in the firm’s accounting reports, the reports of competing firms, announced information relating to the accounting reports, the reports of competing firms, announced information relating to the state of the economy, and any other publicly available information relevant to the state of the economy, and any other publicly available information relevant to the valuation of the firm.valuation of the firm.

Strong-formStrong-form““Stock prices are assumed to reflect ALL information, regardless of them being public or Stock prices are assumed to reflect ALL information, regardless of them being public or private.”private.”Under this form, those who acquire insider information act on it, buying or selling the Under this form, those who acquire insider information act on it, buying or selling the stock. Their actions affect the price of the stock, and the price quickly stock. Their actions affect the price of the stock, and the price quickly adjusts to reflect the insider information.adjusts to reflect the insider information.

EMPIRICAL EVIDENCE ON WEAK-FORM

EFFICIENT MARKET HYPOTHESIS

• SERIAL CORRELATION TEST

• RUNS TEST

• FILTER RULES TEST

• DISTRIBUTION PATTERN

Run TestRun TestMean Run (Mean Run (μμ) = ) =

[(2N[(2N11NN22)/ N)/ N1 + 1 + NN2 2 ] + 1] + 1

Standard Deviation of Run (Standard Deviation of Run (σσ) =) =2N2N11NN22(2N(2N11NN2 2 – N– N11 – N – N22))(N(N1 + 1 + NN22))2 2 (N(N11 + N + N22- 1)- 1)

Z = (R – Z = (R – μμ)/ )/ σσ

EMPIRICAL EVIDENCE ON SEMI-STRONG

FORM HYPOTHESIS

• POSSIBLE TO EARN SUPERIOR RISK-ADJUSTED RETURN BY TRADING ON INFORMATION EVENTS? (EVENT STUDY)

• POSSIBLE TO EARN SUPERIOR RISK-ADJUSTED RETURN … BY TRADING ON AN OBSERVABLE CHARACTERISTIC OF A FIRM? (PORTFOLIO STUDY)-eg. Size of the firm,P/E Ratio etc.

EVENT STUDY

1. IDENTIFY THE ANNOUNCEMENT DATE OF THE EVENT ANNOUNCEMENT DATE

2. COLLECT RETURNS DATA AROUND THE ANNOUNCEMENT DATE

Rj -n Rj,O Rj, +n

-n TO +n

3. CALCULATE THE EXCESS RETURNERj t = Rj t - ( alpha + BETAj(Rmt )

4. COMPUTE THE AVERAGE AND THE STANDARD ERROR OF EXCESS RETURNS ACROSS ALL FIRMS

5. ASSESS WHETHER THE EXCESS RETURNS AROUND THE ANNOUNCEMENT DATE ARE DIFFERENT FROM ZERO

PORTFOLIO STUDY

1. DEFINE THE VARIABLE (CHARACTERISTIC) ON WHICH FIRMS WILL BE CLASSIFIED

2. CLASSIFY FIRMS INTO PORTFOLIOS BASED UPON THE MAGNITUDE OF THE VARIABLE

3. COMPUTE THE RETURNS FOR EACH PORTFOLIO

4. CALCULATE THE EXCESS RETURNS FOR EACH PORTFOLIO

E Rji = Rji – ( Alpha + BETAj x RMt)

5. ASSESS WHETHER THE AVERAGE EXCESS RETURNS ARE DIFFERENT ACROSS THE PORTFOLIOS

EMPIRICAL EVIDENCE ON STRONG-FORM

EFFICIENT MARKET HYPOTHESIS

EMPIRICAL EVIDENCE BROADLY SUGGESTS THE FOLLOWING:

• CORPORATE INSIDERS EARN SUPERIOR RETURNS, AFTER ADJUSTMENT FOR RISK.

• MUTUAL FUND MANAGERS, ON AVERAGE, DO NOT EARN SUPERIOR RETURNS AFTER ADJUSTMENT FOR RISK.

OTHER EVIDENCE

PRICE OVERREACTIONS

CALENDAR ANOMALIES

Implications of Market Efficiency Implications of Market Efficiency HypothesisHypothesis

If Weak-form of the hypothesis is valid:If Weak-form of the hypothesis is valid:– Technical analysis or charting becomes ineffective. You Technical analysis or charting becomes ineffective. You

won’t be able to gain abnormal returns based on it.won’t be able to gain abnormal returns based on it.If Semi-strong form of the hypothesis is valid:If Semi-strong form of the hypothesis is valid:– No analysis will help you attain abnormal returns as long No analysis will help you attain abnormal returns as long

as the analysis is based on publicly available as the analysis is based on publicly available information.information.

If Strong-form of the hypothesis is valid:If Strong-form of the hypothesis is valid:– Any effort to seek out insider information to beat the Any effort to seek out insider information to beat the

market are ineffective because the price has already market are ineffective because the price has already reflected the insider information. Under this form of the reflected the insider information. Under this form of the hypothesis, the professional investor truly has a zero hypothesis, the professional investor truly has a zero market value because no form of search or processing of market value because no form of search or processing of information will consistently produce abnormal returns.information will consistently produce abnormal returns.

As an Analyst & Investment ManagerAs an Analyst & Investment Manager– If market is efficient, what is your If market is efficient, what is your marginalmarginal

contribution for the securities firm that hire contribution for the securities firm that hire you? It should be zero, because you are not you? It should be zero, because you are not able to spot mis-priced securities to produce able to spot mis-priced securities to produce additional increment of return on the portfolios additional increment of return on the portfolios that you are managing. that you are managing. Heat Debate.Heat Debate.

– Analysts’ Analysts’ totaltotal contribution to the society contribution to the society should be big. Because in scouting the capital should be big. Because in scouting the capital market, they essentially make sure asset market, they essentially make sure asset prices are effective as signals to others.prices are effective as signals to others.

Why do We Care about Capital Why do We Care about Capital Market Efficiency?Market Efficiency?

– Investment decisions of the managers of any Investment decisions of the managers of any firms are based to a large extent on signals firms are based to a large extent on signals they get from the capital market. they get from the capital market.

– If the market is efficient, the cost of acquiring If the market is efficient, the cost of acquiring capital will accurately reflect the prospects for capital will accurately reflect the prospects for each firm. each firm.

– This means the firms with the most attractive This means the firms with the most attractive investment opportunities will be able to obtain investment opportunities will be able to obtain capital at a fair price which reflects their true capital at a fair price which reflects their true potential. potential.

– The “right” investment will be made, and the The “right” investment will be made, and the society is said to be “allocationally-efficient”. society is said to be “allocationally-efficient”. Everyone’s better off.Everyone’s better off.

Why do We Care about Capital Why do We Care about Capital Market Efficiency?Market Efficiency?

As a Corporate Financial ManagerAs a Corporate Financial Manager– To raise capital, you consider getting debt- or To raise capital, you consider getting debt- or

equity-financing. equity-financing. – If the market is efficient, you know that equity-If the market is efficient, you know that equity-

financing requires a rate of return which is “fair” financing requires a rate of return which is “fair” because the price has already reflected all because the price has already reflected all available information.available information.

– If the market is efficient, you would never feel your If the market is efficient, you would never feel your firm’s stock being under- or over-valued at any firm’s stock being under- or over-valued at any point in time. In essence, there is no timing point in time. In essence, there is no timing decision to issuing equity.decision to issuing equity.

– More profoundly, if market is efficient, every More profoundly, if market is efficient, every alternative way of raising capital would require the alternative way of raising capital would require the same rate of return for the same project. And no same rate of return for the same project. And no one capital-raising method is superior than the one capital-raising method is superior than the other.other.

Why do We Care about Capital Why do We Care about Capital Market Efficiency?Market Efficiency?

As a Marketing ManagerAs a Marketing Manager– You may consider advertising at the Wall You may consider advertising at the Wall

Street Journal about how impressive your Street Journal about how impressive your company has done throughout the past few company has done throughout the past few years.years.

– If the market is efficient, there is no need to do If the market is efficient, there is no need to do that. Because your stock price has already that. Because your stock price has already reflected those. There is absolutely no impact reflected those. There is absolutely no impact for the ad on the stock price. And placing an ad for the ad on the stock price. And placing an ad is like burning money.is like burning money.

– Another interpretation is that, “ads don’t easily Another interpretation is that, “ads don’t easily fool investors.”fool investors.”

Why do We Care about Capital Why do We Care about Capital Market Efficiency?Market Efficiency?

As an Accounting ManagerAs an Accounting Manager– Will change in accounting procedures (e.g., Will change in accounting procedures (e.g.,

different depreciation methods: straight-line vs different depreciation methods: straight-line vs accelerated) impact the company’s stock accelerated) impact the company’s stock price?price?

– No if the market is semi-strong efficient. No if the market is semi-strong efficient. Because informed, rational analysts will adjust Because informed, rational analysts will adjust the different accounting procedures used by the different accounting procedures used by different firms and assess prospects based on different firms and assess prospects based on standardized numbers.standardized numbers.

– Thus, the adjustment in accounting technique Thus, the adjustment in accounting technique will have no effect on the opinions of those will have no effect on the opinions of those analysts or on the stock price of the firm.analysts or on the stock price of the firm.

Why do We Care about Capital Why do We Care about Capital Market Efficiency?Market Efficiency?

Basic Traits of EfficiencyBasic Traits of EfficiencyAn efficient market exhibits certain behavioral An efficient market exhibits certain behavioral traits. We can examine the real market to see if traits. We can examine the real market to see if it conforms to these traits. If it doesn’t, we can it conforms to these traits. If it doesn’t, we can conclude that the market is inefficient.conclude that the market is inefficient.

1.1. Act to new information quickly and accuratelyAct to new information quickly and accurately2.2. Price movement is unpredictable (memory-less)Price movement is unpredictable (memory-less)3.3. No trading strategy consistently beat the marketNo trading strategy consistently beat the market4.4. Investment professionals not that professionalInvestment professionals not that professional

1) Act to News Quickly & 1) Act to News Quickly & AccuratelyAccurately

00 +t+t-t-t

The timing for a positive news

Days relative to announcement day

Sto

ck p

rice

($)

1) Act to News Quickly & Accurately1) Act to News Quickly & Accurately

00 +t+t-t-t

Days relative to announcement daySto

ck p

rice

($)

If the market is efficient,

1) at time 0, the positive news come, there is an immediate up in the stock price to the RIGHT level. (i.e., the PINK path)

2) There is no delays in analyzing news and slowly reflecting in the stock price like the ORANGE path does.

3) There is also no over-reaction like the BLUE path does, and then subsequently adjustment back to the correct level.

2) Memory-Less Price Movement2) Memory-Less Price Movement

If the market is efficient (WEAK-FORM),

1) The so-called “momentum” is nothing. (Google “Stock momentum”)

“momentum” is like, if once started on a downward slide, stock prices develop a propensity to continue sliding. The expected change in today’s price would, in fact, be related (correlated positively) with the price changes in the past.

2) If the market is efficient, prices only move in response to “news”. More precisely, “news” is any discrepancy between the public’s expectation and the actual realized event. E.g, “If everyone expects Wal-Mart’s sales to go up by 50%, and if the news announces that it did go up by 50%, this is not a news. If it goes up by 30% instead, it is a news, a negative one though.”

3) To detect “memory” or “momentum”, we try to see if

Cov(ΔPt, ΔPt-i) is significantly different from zero or not, for i ≠ 0

3) No Superior Trading Strategies3) No Superior Trading Strategies• One way to test for market efficiency is to test

whether a specific trading rule or investment strategy, would have CONSISTENTLY produced abnormally high return.

4) Professionals aren’t That Professional4) Professionals aren’t That Professional• If professional investors consistently beat the

market, we conclude that the market is not that efficient.

• If the market is really efficient, we should not see professionals making abnormally high returns.