Capital Market Efficiency

What if
What if you have figured the following:
Buy if out of the 20 trading days for the past month, stock XYZ has been rising for more than 2/3 of the times. Sell if out of the 20 trading days for the past month, stock XYZ has been falling for more than 2/3 of the times. Follow this rule strictly, return is abnormally high.

Stock Price Reflects Information

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

Price Movement Pattern

Stock Price Investor behavior tends to eliminate any profit opportunity associated with stock price patterns. Sell Sell Buy Buy 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.

Time

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

Implications
Competition for finding mispriced securities is fierce. Such competition always kills the sureprofit pattern because were there one, it would have been exploited by someone who first spotted it. Thus, roughly speaking, no arbitrage should hold. The implications: stock prices should have reflected all available information. stock prices should be unpredictable.

Unpredictability
Prices are unpredictable in the sense that stock prices should have reflected all available information. Thus if stock prices change, it should be reacting only to new information. The fact that information is new 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 Efficiency
If all past information is incorporated in the price then it should be impossible to consistently beat the market using technical analysis and the like. Definition 1:
Eugene Fama defined Market Efficiency as the state where "security prices reflect all available information.

Definition 2:
Financial markets are efficient if current asset prices fully reflect all currently available relevant information.

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

Fama Formulation of the Efficient Market Model

E(Pj t + i/ t) = [1 + E(rj t + i/ t)]Pjt
E(Pj t + i/ t) = Expected end of the period price of security j given the information beginning of the period. E(rj t + i/ t) = Expected return over the forthcoming period on the basis of information available in the beginning of the year. Pjt = Price of the security j at the beginning of the period.

Subsets of Available Information For a Given Stock

All Available Information including inside or private information All Public Information

Information in past stock prices

3 Forms of Market Efficiency Hypothesis

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

All Public Information

Information in past stock prices

[1] Strong-form - ALL available info [2] Semi-strong form

- ALL available info

[3] Weak-form - ALL available info

3 Forms of Market Efficiency Hypothesis Weak-form

Stock prices are assumed to reflect any information that may be contained in the past history of the stock price itself. 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 following year. Under the weak-form of the hypothesis, the market will come to recognize this and price the phenomenon away.

Semi-strong-form
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 firms 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 valuation of the firm.

Strong-form
Stock prices are assumed to reflect ALL information, regardless of them being public or private. 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 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 Test
Mean Run () = [(2N1N2)/ N1 + N2 ] + 1 Standard Deviation of Run () = 2N1N2(2N1N2 N1 N2) (N1 + N2)2 (N1 + N2- 1) Z = (R )/

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 RETURN ERj 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 Hypothesis

If Weak-form of the hypothesis is valid:
Technical analysis or charting becomes ineffective. You wont be able to gain abnormal returns based on it. No analysis will help you attain abnormal returns as long as the analysis is based on publicly available information. Any effort to seek out insider information to beat the market are ineffective because the price has already reflected the insider information. Under this form of the hypothesis, the professional investor truly has a zero market value because no form of search or processing of information will consistently produce abnormal returns.

If Semi-strong form of the hypothesis is valid:

If Strong-form of the hypothesis is valid:

Why do We Care about Capital Market Efficiency?

As an Analyst & Investment Manager
If market is efficient, what is your marginal contribution for the securities firm that hire you? It should be zero, because you are not able to spot mis-priced securities to produce additional increment of return on the portfolios that you are managing. Heat Debate. Analysts total contribution to the society should be big. Because in scouting the capital market, they essentially make sure asset prices are effective as signals to others.

Why do We Care about Capital Market Efficiency?

Investment decisions of the managers of any firms are based to a large extent on signals they get from the capital market. If the market is efficient, the cost of acquiring capital will accurately reflect the prospects for each firm. This means the firms with the most attractive investment opportunities will be able to obtain capital at a fair price which reflects their true potential. The right investment will be made, and the society is said to be allocationally-efficient. Everyones better off.

Why do We Care about Capital Market Efficiency?

As a Corporate Financial Manager

To raise capital, you consider getting debt- or equity-financing. If the market is efficient, you know that equity-financing requires a rate of return which is fair because the price has already reflected all available information. If the market is efficient, you would never feel your firms stock being under- or over-valued at any point in time. In essence, there is no timing decision to issuing equity. More profoundly, if market is efficient, every alternative way of raising capital would require the same rate of return for the same project. And no one capital-raising method is superior than the other.

Why do We Care about Capital Market Efficiency?

As a Marketing Manager
You may consider advertising at the Wall Street Journal about how impressive your company has done throughout the past few years. If the market is efficient, there is no need to do that. Because your stock price has already reflected those. There is absolutely no impact for the ad on the stock price. And placing an ad is like burning money. Another interpretation is that, ads dont easily fool investors.

Why do We Care about Capital Market Efficiency?

As an Accounting Manager
Will change in accounting procedures (e.g., different depreciation methods: straight-line vs accelerated) impact the companys stock price? No if the market is semi-strong efficient. Because informed, rational analysts will adjust the different accounting procedures used by different firms and assess prospects based on standardized numbers. Thus, the adjustment in accounting technique will have no effect on the opinions of those analysts or on the stock price of the firm.

Basic Traits of Efficiency

An efficient market exhibits certain behavioral traits. We can examine the real market to see if it conforms to these traits. If it doesnt, we can conclude that the market is inefficient.
1. 2. 3. 4. Act to new information quickly and accurately Price movement is unpredictable (memory-less) No trading strategy consistently beat the market Investment professionals not that professional

1) Act to News Quickly & Accurately

Stock price ($) Days relative to announcement day

-t

0
The timing for a positive news

+t

Stock price ($)

1) Act to News Quickly & Accurately

Days relative to announcement day

-t
If the market is efficient,

+t

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 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 todays 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 publics expectation and the actual realized event. E.g, If everyone expects Wal-Marts 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(Pt, Pt-i) is significantly different from zero or not, for i 0

3) 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 arent 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.