Chapter 9 The Capital Markets and Market Efficiency

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Chapter 9The Capital Markets and Market
Efficiency
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Outline

• Introduction
• Role of the capital markets
• Efficient market hypothesis
• Anomalies

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Introduction

• Capital market theory springs from the notion
  that
• People like return
• People do not like risk
• Dispersion around expected return is a reasonable
  measure of risk

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Role of the Capital Markets

• Definition
• Economic function
• Continuous pricing function
• Fair price function

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Definition

• Capital markets trade securities with lives of
  more than one year
• Examples of capital markets
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• Chicago Board of Trade
• Chicago Board Options Exchange (CBOE)

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Economic Function

• The economic function of capital markets
  facilitates the transfer of money from savers to
  borrowers
• E.g., mortgages, Treasury bonds, corporate stocks
  and bonds

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Continuous Pricing Function

• The continuous pricing function of capital
  markets means prices are available moment by
  moment
• Continuous prices are an advantage to investors
• Investors are less confident in their ability to
  get a quick quotation for securities that do not
  trade often

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Fair Price Function

• The fair price function of capital markets means
  that an investor can trust the financial system
• The function removes the fear of buying or
  selling at an unreasonable price
• The more participants and the more formal the
  marketplace, the greater the likelihood that the
  buyer is getting a fair price

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Efficient Market Hypothesis

• Definition
• Types of efficiency
• Weak form
• Semi-strong form
• Strong form
• Semi-efficient market hypothesis
• Security prices and random walks

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Definition

• The efficient market hypothesis (EMH) is the
  theory supporting the notion that market prices
  are in fact fair
• The EMH is perhaps the most important paradigm in
  finance

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Types of Efficiency

• Operational efficiency measures how well things
  function in terms of speed of execution and
  accuracy
• It is a function of the number of order that are
  lost or filled incorrectly
• It is a function of the elapsed time between the
  receipt of an order and its execution

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Types of Efficiency (contd)

• Informational efficiency is a measure of how
  quickly and accurately the market reacts to new
  information
• It relates directly to the EMH
• The market is informationally very efficient
• Security prices adjust rapidly and accurately to
  new information
• The market is still not completely efficient

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Weak Form

• Definition
• Charting
• Runs test

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Definition

• The weak form of the EMH states that it is
  impossible to predict future stock prices by
  analyzing prices from the past
• The current price is a fair one that considers
  any information contained in the past price data
• Charting techniques or of no use in predicting
  stock prices

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Definition (contd)

• Example
• Which stock is a better buy?

Stock A
Current Stock Price
Stock B
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Definition (contd)

• Example (contd)
• Solution According to the weak form of the EMH,
  neither stock is a better buy, since the current
  price already reflects all past information.

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Charting

• People who study charts are technical analysts or
  chartists
• Chartists look for patterns in a sequence of
  stock prices
• Many chartists have a behavioral element

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Runs Test

• A runs test is a nonparametric statistical
  technique to test the likelihood that a series of
  price movements occurred by chance
• A run is an uninterrupted sequence of the same
  observation
• A runs test calculates the number of ways an
  observed number of runs could occur given the
  relative number of different observations and the
  probability of this number

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Conducting A Runs Test
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Semi-Strong Form

• The semi-strong form of the EMH states that
  security prices fully reflect all publicly
  available information
• E.g., past stock prices, economic reports,
  brokerage firm recommendations, investment
  advisory letters, etc.

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Semi-Strong Form (contd)

• Academic research supports the semi-strong form
  of the EMH by investigating various corporate
  announcements, such as
• Stock splits
• Cash dividends
• Stock dividends
• This means investor are seldom going to beat the
  market by analyzing public news

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Strong Form

• The strong form of the EMH states that security
  prices fully reflect all public and private
  information
• This means even corporate insiders cannot make
  abnormal profits by using inside information
• Inside information is information not available
  to the general public

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Semi-Efficient Market Hypothesis

• The semi-efficient market hypothesis (SEMH)
  states that the market prices some stocks more
  efficiently than others
• Less well-known companies are less efficiently
  priced
• The market may be tiered
• A security pecking order may exist

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Security Prices and Random Walks

• The unexpected portion of news follows a random
  walk
• News arrives randomly and security prices adjust
  to the arrival of the news
• We cannot forecast specifics of the news very
  accurately

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Anomalies

• Definition
• Low PE effect
• Low-priced stocks
• Small firm effect
• Neglected firm effect
• Market overreaction
• January effect

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Anomalies (contd)

• Day-of-the-week effect
• Turn-of-the calendar effect
• Persistence of technical analysis
• Chaos theory

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Definition

• A financial anomaly refers to unexplained results
  that deviate from those expected under finance
  theory
• Especially those related to the efficient market
  hypothesis

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Low PE Effect

• Stocks with low PE ratios provide higher returns
  than stocks with higher PEs
• Supported by several academic studies
• Conflicts directly with the CAPM, since study
  returns were risk-adjusted (Basu)

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Low-Priced Stocks

• Stocks with a low stock price earn higher
  returns than stocks with a high stock price
• There is an optimum trading range
• Every stock with a high stock price should split

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Small Firm Effect

• Investing in firms with low market capitalization
  will provide superior risk-adjusted returns
• Supported by academic studies
• Implies that portfolio managers should give small
  firms particular attention

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Neglected Firm Effect

• Security analysts do not pay as much attention to
  firms that are unlikely portfolio candidates
• Implies that neglected firms may offer superior
  risk-adjusted returns

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Market Overreaction

• The tendency for the market to overreact to
  extreme news
• Investors may be able to predict systematic price
  reversals
• Results because people often rely too heavily on
  recent data at the expense of the more extensive
  set of prior data

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January Effect

• Stock returns are inexplicably high in January
• Small firms do better than large firms early in
  the year
• Especially pronounced for the first five trading
  days in January

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January Effect (contd)

• Possible explanations
• Tax-loss trading late in December (Branch)
• The risk of small stocks is higher early in the
  year (Rogalski and Tinic)

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Types of Firms in January
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Day-of-the-Week Effect

• Mondays are historically bad days for the stock
  market
• Wednesday and Fridays are consistently good
• Tuesdays and Thursdays are a mixed bag

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Day-of-the-Week Effect (contd)

• Should not occur in an efficient market
• Once a profitable trading opportunity is
  identified, it should disappear
• The day-of-the-week effect continues to persist

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Turn-of-the-Calendar Effect

• The bulk of returns comes from the last trading
  day of the month and the first few days of the
  following month
• For the rest of the month, the ups and downs
  approximately cancel out