Efficient Market Theory

1
Efficient Market Theory

• Financial Management (ECO506C1)

2
Overview

• Efficiency - Definition
• Random Walk Theory
• Randomness and the Efficient Market Hypothesis
  (EMH)
• CAPM and Efficiency
• Evidence concerning Efficiency
• What if Efficiency Does Not Hold?

3
What Do We Mean By Efficiency?

• Reflect all available information
• Prices reflect the markets best estimate of
  their expected return and risk

4
Random Walk Theory

• Randomness
• Random walk and Bachelier (1900)
• Price changes are independent of one-another
• Pt1 - Pt independent of Pt - Pt-1
• Tested by Moore (1962)

5
Randomness and the Efficient Market Hypothesis
(EMH)

• Why do stock price follow a random walk?
• Theory
• Levels of information
• Share price information
• Information independent

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Levels of Market Efficiency

• Fama (1970)
• Type or scope of information
• Three levels
• Weak form
• Semi Strong form
• Strong form

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Weak Form Efficiency

• Past share prices
• Charts no patterns
• Trading rules

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Semi Strong Form Efficiency

• Public information ? Excess profits

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Strong Form Efficiency

• Inside information
• Already absorbed

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Efficiency Redefined

• Speed Efficiency
• Fair Game

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The Abnormal or Excess Return (Algebraically)

• ei,t1 Ri,t1 - E(Ri,t1)/It
• ei,t1 Abnormal return
• Ri,t1 Actual return
• E(Ri,t1) Expected return
• It A particular set of information

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The Fair Game (Algebraically)

• Beat the Market?
• Zero sum gain
• ? ei,t 0

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Empirical Evidence and the EMH (Weak Form)

• Fama (1965)
• Price movements (pattern)
• 30 U.S. companies
• No pattern

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Empirical Evidence and the EMH (Semi Strong Form)

• Fama, Fisher, Jensen Roll (1969)
• Stock splits
• Quick adjustment
• No Excess returns

15
Empirical Evidence and the EMH (Strong Form
Efficiency)

• Levy Lerman (1985)
• Directors share dealing
• Excess returns

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Evidence Contrary to the EMH

• French (1980) - Day of the week
• Marsh (1983) - Month of the year
• Banz (1981) - Small firm effect

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If Efficiency Does not Hold

• Technical Analysis
• Chartism
• Fundamental analysis

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Conclusion on EMH

• Determine investment strategy
• Buy hold
• Active

19
Summary

• Definition
• Random Walk Theory
• Levels of Efficiency
• Abnormal Return
• Fair Game
• Empirical Evidence
• Technical Analysis