CAPITAL MARKET EFFICIENCY

-The Efficient market Hypothesis [EMH]

Prof.S.A.Shamsher

Outline

Capital Market Efficiency

Why

Capital Markets-?
What is it-?
Definition
Forms
Implications

Why Capital Markets Exist

Capital markets facilitate the transfer of
capital (i.e. financial) assets from one owner
to another.
They provide liquidity.
Liquidity refers to how easily an asset can be
transferred without loss of value.

A side benefit of capital markets is that the

transaction price provides a measure of the
value of the asset.

What is it-?
Key

Function of Capital Market-Pricing of

securities
The demand and supply forces help in
determining prices
How efficient is the pricing mechanism of
capital markets-?
The efficiency of pricing mechanism depends
upon the speed of price adjustment to any
available information
The more is the speed of adjustment , the
more efficient will be the security prices and the
more efficient the capital market

Defined
Definition 1
The ability of the securities to reflect and incorporate all
relevant information almost instantaneously in their prices
Definition 2:
Eugene Fama defined Market Efficiency as the state where
"security prices reflect all available information

The Efficient Market Hypothesis

Informational efficiency is a measure of the

level of information disclosure and how
quickly and accurately the market reacts to
new information.

The efficient market hypothesis (EMH) deals

with informational efficiency.
The degree of efficiency depends on the
speed with which the information is
processed and incorporated in the share
prices

Why Should Capital Markets Be

Efficient?
What would be the ingredients of an
information ally efficient market?
A large number of profit-maximizing participants
analyze and value securities
New information regarding securities comes to the
market in a random fashion
Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
Price adjustments are unbiased correct on average.

Under these conditions, a securitys price would

be appropriate for its level of risk.

Why does it matter?

If prices do fully reflect all current information, it would
not be worth an investors time to use information to
find undervalued securities.
If prices do NOT fully reflect information, FIND AND
USE THAT INFORMATION, and perhaps you will be able
to make a killing in the market.
Informationally efficient markets would require some
amount of minimum trading for the prices to adjust the
information.
More the trading , faster the price adjustment and
efficient the market.

Stock Price

The randomness of security prices imply that investors in

the capital market take cognizance of all available
information relating to the security prices and the prices
adjust quickly to such information, how quickly do the
prices adjust to the available information indicates the
degree of efficiency of the capital market
Sell

Sell
Buy

Buy
Investors behaviors tend to eliminate any profit
opportunity associated with stock price patterns.
Time

Three forms of Market Efficiency

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 :

All Public Information

Information
in past stock
prices

[1] Strong -form

- ALL available info
[2] Semi-strong form
- ALL Public information
[3] Weak-form
- Information in past prices

Forms of market efficiency hypothesis

Weak-form
Stock prices are assumed to reflect any information
that may be contained in the past stock prices.

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.
It is also referred to as random walk hypothesis, in other
words prices shall behave randomly, it is therefore not
possible for an investor to predict future security prices by
analyzing historical prices.
Thus any Trading rule that utilizes past data to decide the
future course of action will not help you to gain much.

How do I know that the capital Market is

efficient in its Weak form ?
The correlation between the security prices
over time
In an efficient capital market there should not
exist a significant correlation between security
prices over time
Most empirical studies suggest that there
exists independence between the security
prices over time. In other words share prices
behave randomly

Forms of market efficiency hypothesis

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 past
prices and 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
The publicly available information is therefore already
incorporated in the current security prices, the investor
will not be in a position to predict future security prices by
analyzing the publicly available information

Forms of market efficiency hypothesis

Strong-form
Stock prices are assumed to reflect ALL information,
regardless of them being public or private.
All the information whether public or insider is already
incorporated in the current security prices. the investor
will not be in a position to predict future security prices by
analyzing any sort of information.
This is a very strong form of assertion and evidence has
not supported this form. People with private and insider
information have been in a position to predict future
prices and thereby beat the market.

Three forms 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.

If Semi-strong form of the hypothesis is valid:

No analysis will help you attain abnormal returns as long as
the analysis is based on publicly available information.

If Strong-form of the hypothesis is valid:

Any effort to seek out insider information to beat the
market are ineffective because the price has already
reflected the insider information.

Evidence supports semi strong form

Efficient Markets
and Technical Analysis
Assumptions of technical analysis directly oppose the
notion of efficient markets
Technicians believe that stock prices move in
patterns that persist and are predictable to the
informed investor.
Technical analysts develop systems to detect trends
and patterns in prices
If the capital market is weak-form efficient, a trading
system that depends on past trading data can have
no value

Efficient Markets and Fundamental

Analysis
Fundamental analysis involves determining an
investments intrinsic values based on
company and economic fundamentals
The intrinsic value is compared to the market
price to determine whether the investment is
undervalued or overvalued

In an efficient market, prices already reflect

public information, so determining intrinsic
value using that information is not a
worthwhile exercise

Conclusion

capital market is neither purely efficient nor purely inefficient.

The right question to ask is the degree of efficiency of capital market.
The fact being that the strong form of efficiency in reality does not take place
Therefore opportunities to beat the market do exists. It is for the professional
investor to grab such an opportunity as an when it surfaces
Also then whether a Portfolio would be managed on a passive or active basis
would depend on the degree of the efficiency of the market and the
availability of superior analysts.
EMH indicates that technical analysis would be of no value , fundamental
analysis would work depending on the capacity to make superior projections
that differ from the consensus.
Without access to superior analytical advice , in times of strong levels of
efficiency it is best to manage a portfolio like an index fund or an exchange
traded fund .
Many bright and competing investors have made the game tough, they have
created an almost ideal and efficient market making it difficult for sub
standard investors to achieve abnormal risk adjusted returns.

Event Studies- To test the semi

strong form of efficiency
Calculate the expected and actual return before and after the
event using the market model or the capital asset pricing
model
Calculate the abnormal return as the difference between the
expected return and the actual return
Calculate the CAR- Cumulative Abnormal Return
For the Capital Market to be efficient in the semi strong form ,
the CAR should be zero prior to the event , rise to a positive
number just after the event and then stay stable
In an inefficient capital market , the value of CAR will continue
rising for several weeks after the event

Demonstration of Event studies

using an example