ARE FINANCIAL MARKETS EFFICIENT?

Efficient Market Hypothesis also referred to as the theory of efficient capital markets states that
prices of securities in financial markets fully reflect all available information.
R=Pt +1 – Pt + C
Pt

where R = rate of return on the security held from time t to time t + 1 (say, the
end of 2014 to the end of 2015)
Pt + 1 = price of the security at time t + 1, the end of the holding period
Pt = the price of the security at time t, the beginning of the holding
period
C = cash payment (coupon or dividend payments) made in the period t to
t+1
EXPECTED RETUIRN
Re =Pe t+1 - Pt + C
Pt
Expected return on the security will equal the optimal forecast of the return
Re = Rof
Expected return on a security Re equals the equilibrium return R*, which equates the quantity of
the security demanded to the quantity supplied
Re = R*
Current prices in a financial market will be set so that the optimal forecast of a security’s return
using all available information equals the security’s equilibrium return
Rof = R*

Rationale Behind the Hypothesis

Concept of arbitrage- market participants (arbitrageurs) eliminate unexploited
profit opportunities, meaning returns on a security that are larger than what is
justified by the characteristics of that security.
Two types of Arbitrage:
Pure arbitrage- the elimination of unexploited profit opportunities involves no risk; and
the arbitrageur who takes on some risk when eliminating the unexploited profit opportunities.
Rof > R* Pt Rof
Rof > R* Pt Rof until Rof = R*

In an efficient market, all unexploited profit opportunities will be eliminated. An extremely

important factor in this reasoning is that not everyone in a financial market must be well
informed about a security for its price to be driven to the point at which the efficient market
condition holds.

EVIDENCE ON THE EFFICIENT MARKET HYPOTHESIS

Evidence in Favor of MARKET EFFICIENCY

 Performance of Investment Analysts and Mutual Funds

when you purchase a stock, you cannot expect an abnormally high return which is greater than
the equilibrium return

 Do Stock Prices Reflect Publicly Available Information

stock prices will relfect all publicly available information

 Random-Walk Behavior of Stock Prices

future changes in stock prices should, for all practical purposes, be unpredictable.

 Technical Analysis
use to predict changes, to study past stock price data and search for patterns such as trends and
regular cycles
Evidence Against MARKET EFFICIENCY
 Small-Firm Effect
One of the earliest anomalies. Small firms have earned abnormally high return over a long
periods of time.

 January Effect
Abnormal price rise from December to January. Some financial economists argue that the
January effect is due to tax issues

 Market Overreaction
Stock prices react to news announcements and that the pricing errors are corrected only slowly.

 Excessive Volatility
Stock market appears to display excessive volatility. that is, fluctuations in stock prices may be
much greater than is warranted by fluctuations in their fundamental value

 Mean Reversion
Stocks with low returns today tend to have high returns in the
future, and vice versa.
 New Information Is Not Always Immediately Incorporated into Stock Prices
stock prices adjust rapidly to new information and do not instantaneously adjust to profit
announcements.

Why the Efficient Market Hypothesis Does Not Imply That Financial Markets Are
Efficient
Important implications of market efficiency in academic field of finance:
 It implies that in an efficient capital market, one investment is as good as any other.
 It implies that a security’s price reflects all available information about the intrinsic value
of the security.
 It implies that security prices can be used by managers of both financial and nonfinancial
firms to assess their cost of capital accurately
Bubbles
The prices of assets rise well above their fundamental values.
Behavioral Finance
- New field of study which implies concepts from other social sciences, such as
anthropology, sociology, and particularly psychology. Loss aversion, overconfidence, and
social contagion can explain why trading volume is so high, stock prices get overvalued, and
speculative bubbles occur.
Short Sales
- Borrowing a stock and selling it to the market to earn profit by buying the stock again after
it has fallen in price.
GROUP 5
Orca, Jillian Carisse A. Campos, Ricelle Ann