Market Efficiency

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Chapter 9
Market Efficiency
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Chapter Summary

• Objective To discuss the efficient market
  hypothesis and to examine the empirical evidence
  supporting or not the notion of market
  efficiency.
• The Efficient Market Hypothesis
• Empirical Tests of Market Efficiency

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Efficient Market Hypothesis (EMH)

• Do security prices reflect information ?
• Why look at market efficiency
• Implications for business and corporate finance
• Implications for investment

4
Random Walk and the EMH

• Random Walk - stock price change unpredictably
• Actually stock prices follow a submartingale
• Expected price is positive over time
• Positive trend and random around the trend

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Random Walk with Positive Trend
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Random Price Changes

• Why are price changes random?
• Prices react to information
• Flow of information is random
• Therefore, price changes are random

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EMH and Competition

• Stock prices fully and accurately reflect
  publicly available information
• Once information becomes available, market
  participants analyze it
• Competition assures prices reflect information

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Forms of the EMH

• Weak all past market trading information
• Semi-strong all publicly available information
  regarding the prospects of a firm
• Strong all information relevant to the firm

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Types of Stock Analysis

• Technical Analysis - using prices and volume
  information to predict future prices
• Weak form efficiency technical analysis
• Fundamental Analysis - using economic and
  accounting information to predict stock prices
• Semi strong form efficiency fundamental analysis

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Implications of Efficiency for Active or Passive
Management

• Active Management
• Security analysis
• Timing
• Passive Management
• Buy and Hold
• Index Funds

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Market Efficiency and Portfolio Management

• Even if the market is efficient a role exists for
  portfolio management
• Diversification
• Appropriate risk level
• Tax considerations

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Summary Reminder

• Objective To discuss the efficient market
  hypothesis and to examine the empirical evidence
  supporting or not the notion of market
  efficiency.
• The Efficient Market Hypothesis
• Empirical Tests of Market Efficiency

13
Empirical Tests of Market Efficiency

• Event studies
• Assessing performance of professional managers
• Testing some trading rule

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How Tests Are Structured

• 1. Examine prices and returns over time

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How Tests Are Structured (contd)

• 2. Returns are adjusted to determine if they are
  abnormal
• Market Model approach
• a. Rt a bRmt et
• (Expected Return)
• b. Excess Return (Actual - Expected)
• et Actual - (at btRmt)

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How Tests Are Structured (contd)

• Market Model approach
• c. Cumulate the excess returns over time

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Issues in Examining the Results

• Magnitude Issue
• Selection Bias Issue
• Lucky Event Issue
• Possible Model Misspecification

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What Does the Evidence Show?

• Technical Analysis
• Short horizon
• Long horizon
• Fundamental Analysis
• Anomalies Exist

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Anomalies

• Small Firm Effect (January Effect) even when
  risk-adjusted (tax-loss selling?)
• Neglected Firm require higher returns
• Book to Market Ratios book equity/market equity
  value (proxy for a risk factor that affects
  returns)
• Reversals (longer horizons, performance
  reversals)
• Note above anomalies may actually be
  risk-premiums

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Anomalies (cont.)

• Weekend effect the typical Fri-Mon return was
  smaller than other weekdays
• Inside information (more in Canada)
• Post-Earnings Announcement Drift (after the
  announcement date)

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Explanations of Anomalies

• May be risk premiums
• Behavioral explanations
• Forecasting errors
• Overconfidence
• Regret avoidance
• Framing and mental accounting

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Mutual Fund and Professional Managers Performance

• Some evidence of persistent positive and negative
  performance
• Potential measurement error for benchmark returns
• Style changes (small stocks)
• May be risk premiums (market benchmark?)
• Superstar phenomenon