MARKET EFFICIENCY

1
MARKET EFFICIENCY

• DEFINITION
• KEY ISSUES
• FULLY REFLECT
• SPEED OF INFORMATION
• NOTION NOT RESTRICTED TO CAPITAL MARKETS

2
TESTABLE IMPLICATIONS

• E(Pj, t1 ?t) 1 E(r j, t1 P j,t)
  (1)
• E EXPECTED VALUE OPERATOR
• P j,t PRICE OF SECURITY j AT TIME t
• P j,t1 PRICE OF SECURITY j AT TIME t1
• ?t INFORMATION SET USED IN ESTABLISHING PRICES

3
IMPLICATIONS OF RETURNS BASED ON INFORMATION SET

• RETURNS CANNOT BE GREATER THAN EXPECTED RETURN IN
  ANY STRATEGY BASED ON ?t
• MARKET INFORMATION SET SHOULD INCLUDE ALL
  AVAILABLE INFORMATION
• NO PRICE SENSITIVE INFORMATION IS IGNORED IS
  SETTING PRICES

4
IF NO INFORMATION IS IGNORED, THEN
5
IMPLICATIONS OF EQUATION

• PRICES ASSESSED BY THE MARKET EQUALS PRICES
  IMPLIED BY THE AVAILABLE INFORMATION

6
LEVELS OF EFFICIENCY

• ROBERTS (1959) SUGGEST THREE LEVELS
• WEAK FORM
• SEMI-STRONG FORM
• STRONG FORM EFFICIENCY

7
WEAK FORM EFFICIENCY

• DEFINITION
• ? t-1 (P t-1, P t-2, P t-3.) (3)
• E(P t ? t-1) P t-1 (4)
• THE BEST ESTIMATE OF TOMORROWS PRICE IS TODAYS

8
TESTS OF WEAK FORM EFFICIENCY

• KENDAL (1953)
• TEMPORAL DEPENDENCE OF UK INDUSTRIAL SHARE PRICES
  FROM 1928-1938
• WEAK SERIAL CORRELATIONS WITH LITTLE INVESTMENT
  VALUE

9
WEAK FORM TESTS (CONTD)

• BREALEY(1970)
• EXAMINED SERIAL CORRELATION OF FTA
• SERIAL CORRELATION 0.219 BIAS DUE TO
  NON-SYNCHRONOUS TRADING
• DRYDEN (1970)
• PRICES FOLLOW RANDON WALK
• KEMP REID (1971)
• 52 DAILY PRICE OBSERVATIONS EXAMINED
• SHARE PRICE MOVEMENTS CONSPICIOUSLY NON-RANDOM
  OVER PERIOD CONSIDERED
• SOLNIK (1973)
• SERIAL CORRELATION OF 0.072 FOR UK

10
WEAK FORM TESTS (CONTD)

• GUY (1975)
• EXAMINES TEMPORAL DEPENDENCE AND CONCLUDE THAT
  MARKET IS INEFFICIENT ARGUES NO STRONG CASE CAN
  BE MADE
• BREALEY (1970
• EXAMINES TRADING STRATEGIES ON THE BASIS OF
  SERIAL CORRELATION IDENTIFIED (0.219)
• DELAYED RESPONSE INSUFFICIENT TO EARN SIGNIFICANT
  PROFIT AFTER DEALING COSTS
• CUNNINGHAM (1973)
• EXAMINES FT INDUSTRIAL INDEX 1935-1969 (1800
  WEEKLY OBSERVBATION
• COULD PROFIT FROM PAST PRICE BEHAVIOUR

11
WEAK FORM TESTS (CONTD)

• OPONG ET AL (1999)
• HAMIL, OPONG, SPREVAK (2000)
• OPONG, MCILKENNY AND BIEKPE (2000)
• HSIEH (199), ELDRIDGE ET AL (1993) PETERS (1994)
• GREENE AND FIELTZ (1977) PANDEY ET AL (1997)

12
Return to NPV

• NPV employs discount rates.
• These discount rates are risk adjusted.
• The risk adjustment is a byproduct of market
  established prices.
• Adjustable discount rates change asset values.

13
Return to NPV

• Example
• The government is lending you 100,000 for 10
  years at 3 and only requiring interest payments
  prior to maturity. Since 3 is obviously below
  market, what is the value of the below market
  rate loan?

14
Return to NPV

• Example
• The government is lending you 100,000 for 10
  years at 3 and only requiring interest payments
  prior to maturity. Since 3 is obviously below
  market, what is the value of the below market
  rate loan?
• Assume the market return on equivalent risk
  projects is 10.

15
Random Walk Theory

• The movement of stock prices from day to day DO
  NOT reflect any pattern.
• Statistically speaking, the movement of stock
  prices is random (skewed positive over the long
  term).

16
Random Walk Theory
SP Index 1980-1984
17
Random Walk Theory
CUMULATED RANDOM NUMBERS
18
Random Walk Theory
Returns for two successive days from 1993-1994
19
Random Walk Theory
20
(No Transcript)
21
RANDOM WALK THEORY
22
Random Walk Theory
23
Random Walk Theory
24
Random Walk Theory
25
Efficient Market Theory

• Fundamental Analysts
• Research the value of stocks using NPV and other
  measurements of cash flow.

26
Efficient Market Theory

• Technical Analysts
• Forecast stock prices based on the watching the
  fluctuations in historical prices (thus wiggle
  watchers).

27
Efficient Market Theory
90 70 50
Microsoft Stock Price
Cycles disappear once identified
Last Month
This Month
Next Month
28
SEMI-STRONG FORM EFFICIENCY

• DEFINITION
• PRICES REFLECT ALL PUBLICLY AVAILABLE INFORMATION
• TESTING IMPLICATIONS
• ABNORMAL RETURNS EQUALS ZERO AFTER THE RELEASE OF
  PUBLIC INFORMATION

29
EMPIRICAL EVIDENCE

• BALL AND BROWN (1968)
• BEAVER (1968)
• FAMA, FISHER, JENSEN ROLL (1969)
• FIRTH (1981)
• OPONG (1989, 1995, 1996, 1999)

30
Efficient Market Theory
Announcement Date
31
Example How stock splits affect value
-29
0
30
Source Fama, Fisher, Jensen Roll
32
STRONG FORM EFFICIENCY

• DEFINITION
• PRICES REFLECT ALL INFORMATION (BOTH PUBLIC AND
  PRIVATE)
• TESTING IMPLICATIONS

33
Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and
the Market Index
34
Efficient Market Theory
IPO Non-Excess Returns
Year After Offering
35
Efficient Market Theory
1987 Stock Market Crash
36
Efficient Market Theory
1987 Stock Market Crash
37
Lessons of Market Efficiency

• Markets have no memory
• Trust market prices
• Read the entrails
• There are no financial illusions
• The do it yourself alternative
• Seen one stock, seen them all