Market Efficiency

1
Chapter 12

• MarketEfficiency

2
Efficient Market Hypothesis (EMH)

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

3
Random Walk and the EMH

• Random Walk - stock prices are random
• Actually submartingale
• Expected price is positive over time
• Positive trend and random about 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
• Semi-strong
• Strong

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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
• Appropriate risk level
• Tax considerations
• Other considerations

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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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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 at btRmt et
• (Expected Return)
• b. Excess Return (Actual - Expected)
• et Actual - (at btRmt)

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How Tests Are Structured (contd)

• 2. Returns are adjusted to determine if they are
  abnormal
• Market Model approach
• c. Cumulate the excess returns over time

0
t
-t
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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)
• Neglected Firm
• Market to Book Ratios
• Reversals
• Post-Earnings Announcement Drift
• Market Crash of 1987

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Mutual Fund and Professional Manager Performance

• Some evidence of persistent positive and negative
  performance
• Potential measurement error for benchmark returns
• Style changes
• May be risk premiums
• Superstar phenomenon