Lecture 2

Chapter 14
Efficient Capital Markets

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 Outline
1. Definition of Efficient Market Hypothesis (EMH)
2. Three forms of EMH
3. Tests on three forms of EMH
4. Empirical challenges to EMH and behavioral finance

2
Market Price vs. True Value
The differences in market price vs. true value
True value is also called fair value, intrinsic value

Market price = $30

True value = $35
 The present value of a firm’s expected future net
cash flows discounted by the required rate of
return.
What to do?
 intrinsic value > market price
 intrinsic value < market price
 intrinsic value = market price

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1. Efficient Market Hypothesis (EMH)

Definition: Markets are efficient if prices of securities fully

reflect all available information about securities; that is,

market price = true value, given available information

The belief in market efficiency is called Efficient Market

Hypothesis (EMH)

Available information include

- past price & volume => weak form EMH
- all public information => semi-strong form EMH
- all public & insider information => strong form EMH

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 2. Three Forms of Efficiency by Information Type

Note the definition of efficiency is with respect to information set 

• Weak form:  = past price information
• Semi-strong form:  = all public information
• Strong form:  = all information
Semistrong Form
(Publicly available)
Weak Form Strong Form
(Past prices & volume) (All)

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 Sources of Market Efficiency

 Many highly paid analysts are searching for ways to

improve investment performance.
 Competition among these analysts make mispriced
securities difficult to find.

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An Example to Demonstrate How
Competition Leads To Market Efficiency
Prices

Time
7
 Implications of EMH
 Prices change only due to new information and new
information is reflected in market price quickly
Speed is very quick and magnitude is appropriate
 Investors cannot predict future price (or price change),
because the news arrives randomly and the investors
don’t know the timing of news.
Stock price changes are random and unpredictable
 Investors cannot make abnormal return on their
investment
Portfolio choice and expected return depends on
investors’ risk preference only, i.e.
E(Ri) = Rf + Beta*(Rm – Rf),
where Beta = cov(Ri,Rm)/var(Rm)
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Efficient Price Reaction to New Information

CAR
Overreaction
and reversion

Early
response

Delayed
response
Efficient market
response to new info
Days before (-) and
-30 0 +30 after announcement
announcement day 99
2a. Weak-form EMH
 Security prices should have reflected all historical price
information

 In equilibrium, no abnormal return can be earned by

analyzing past price charts, because competition for
investment profits should have removed any profitable
trend in price/return

 Technical Analysis
 Technical analysis is a security analysis methodology
for forecasting the direction of prices through the
study of past market data, primarily price and volume.

 Weak-form EMH indicates technical analysis has NO

value to investors
 But, why do we always see stock price charts on
newspapers?
10
2b. Semistrong-form EMH
 Prices should have reflected all public information (eg.
corporate annual reports, financial analysts’ reports,
government policies)
 In semi-strong form efficient market, no abnormal return
can be earned by analyzing public information

 Fundamental Analysis
 Fundamental analysis is a security analysis
methodology for forecasting the direction of prices
through the study of public information

 Semi-strong form EMH indicates fundamental analysis

has NO value to investors
 But, why do we always see discussions on corporate
fundamentals, government policies, and etc? 11
2c. Strong-form EMH

Prices should have reflected all private and public info,

In strong-form efficient market, even insiders cannot earn

abnormal returns

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3a. Test of Weak-form EMH
 Weak-form EMH implies: Corr(Rt , Rt-1) = 0
 Weak-form EMH mainly supported by real transaction data
 Prices follow random-walk; low serial correlation
 Table 14.1

 Anomaly: Short-run Momentum strategy

 Long high past 6-month ret stocks and simultaneously sell low
past 6-month ret stocks
 The trading strategy will generate annual abnormal return of 13%

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Table 14.1

Company Serial Corr Coefficient

Boeing 0.0025
Citigroup -0.0078
Coca-cola 0.0189
IBM 0.0126
McDonald’s 0.0054
Merck 0.0409
Pfizer 0.0225
The Gap 0.0193

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 3b. Test of Semistrong-form EMH
 Event-study is used to test semi-strong form EMH
 Test how the stock price reacts upon the announcement of firm-specific
info (eg. earnings announcement, dividend omission/ increase, CEO
turnover)

 The implementation of event study involves the

computation of abnormal return (AR) and cumulative
abnormal return (CAR)
 CAR is the summation of AR over a few days; CAR captures the total
market reaction to news

 AR on a given stock for a particular day can be calculated

 by subtracting the market’s return on the same day (Rmt) from the actual
return (Rit) on the stock for that day:
 ARit= Rit – Rmt (1)
 or by using the market model approach:
 ARit= Rit – (ait + bit*Rmt) (2)
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To understand approach (2)

Estimate the model Rit = ait + bitRmt + eit during the estimation window
Find the model parameters ait and bit using statistic software
Compute AR over the event window

-90 -30 -2 -1 0 +1 +2

Estimation window Event window

Equation (2) is better than equation (1) because it recognizes the fact that
the impacts of market movement on different firms are different.

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CAR example

T R(HSBC) R(HSI) AR CAR

1 4% 3%

2 1% -1%

3 1% -2%

Regression: Rit = 0 + 0.7 Rmt+ eit

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 Empirical Evidence For Semi-strong
Form EMH
 Supportive evidences to semi-strong form EMH
 Evidence from event studies (Fig 14.5)
 Mutual fund performance (Fig 14.6)

 Unsupportive evidences to semi-strong form EMH

 Size effect: Large vs small firms
 Size = price*shares outstanding
 Small size firms tend to outperform large size firms
 Value effect: High vs low B/M stocks
 B/M=book value of equity / market value of equity
 High book-to-market ratio firms tend to outperform low
book-to-market firms

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Supportive evidence to semi-strong form
EMH: Dividend Omissions

Cumulative Abnormal Returns for Companies Announcing

Cumulative abnormal returns

Dividend Omissions

0.146 0.108
(%)

0.032 0
-0.244
-8 -6 -4
-0.72 -2 -0.483 0 2 4 6 8
-1

-2
Efficient market
response to “bad
-3
-3.619
news” -4.563 -4.685-4.49
-4

-4.898 -4.747
-5 -5.015 -5.183
-5.411
-6

Days relative to announcement of dividend omission

1919
Supportive evidence to semi-strong
form EMH: Record of Mutual Funds

All funds Small- Other- Growth Income Growth and Maximum Sector
company aggressive income capital gains
-1.06%
growth growth -0.39% -0.51%
-2.13% -2.17% -2.29%

-5.41%

-8.45%

Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,”
Journal of Financial Exonomics, 63 (2002).

2020
Unsupportive evidence to semi-strong form EMH:
Stock Performance of Berkshire Hathaway

1990-2007: ret(SP500)=8%; ret(BRKA)=16% 2121

c. Test of Strong-form EMH

 Measure the return on insiders’ trading on firm

specific information
 Strong form efficiency is not supported
Insiders make abnormal profits trading on
‘insider’ (private) information

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Implications of EMH for Corporate Finance

 Security prices reflect information quickly and fairly

 For investors, they will only expect to obtain a normal rate
of return for their investment in any firm
Awareness of information when it is released does an
investor little good. The price adjusts before the investor
has time to act on it.
 For the firms, they will only expect to receive fair value for
securities that they sell
Fair value = the present value of future cash flows
Thus, corporate managers should NOT expect any
opportunities to fool investors in efficient markets.

2323
 Behavioral Critics to Market Efficiency

 Crashes
On Oct 19, 1987, stock market dropped 20-25%, not
much news.
 Bubbles
Dot.com bubble of late 1990s
=> Emergence of Behavioral Finance that explains stock
price changes from psychological and cognitive
perspective

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Summary
 Efficient market:
 Market price reacts to new information quickly
=> market price = true value

 EMH => no abnormal return to investors

Form Information Test
Weak Past information corr(Rt,Rt+1)
Momentum strategy
Semi-strong Public information Event study, mutual fund
performance, anomalies
Strong All information Profits from insider trading

 Research shows stock prices tend to follow random walk; empirical studies
have shown that technical analysis does not generate trading profits
 Several anomalies exist regarding semi-strong form EMH
 Empirical findings on insider trading suggests strong form efficiency does not
hold
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