The Efficient Market Hypothesis

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Department of Banking and Finance
SPRING 2007-08

• The Efficient Market Hypothesis

by Asst. Prof. Sami Fethi
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Efficient Market Hypothesis (EMH)

• What is meant by efficiency?
• Efficiency means if security prices rationally
  reflect available information.
• What is meant by efficiency market Hypothesis?
• This means that if new information is revealed
  about a firm, it will be incorporated into the
  share price rapidly and rationally wrt the
  direction of the share price movement and the
  size of that movement.
• Do security prices reflect information ?
• This means that there exists a random walk
  effect.

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Efficient Market Hypothesis (EMH)-Definition

• Efficient market hypothesis the notion that
  stocks fully reflect all available information or
  prices of securities fully reflect available
  information about securities.
• The efficient market hypothesis (EMH) holds that
  a stock market is efficient if the market price
  of a companys shares (or the financial
  securities, such as bonds), rapidly and correctly
  reflects all relevant information as it becomes
  available (Lumby 1992352).

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Efficient Market Hypothesis (EMH)-Definition

• Fama (1970) defines efficiency as prices always
  fully reflect available information and he
  explains some sufficient conditions for
  efficiency
• There are no transaction costs in trading
  securities
• All market participants can obtain costless
  information
• All agree on the implications of current
  information for the current price and
  distributions of future price of each security.
• The efficient market means that the prices of
  stocks and commodities follow a random walk.

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Random Walk and the EMH

• Random walk theory asumes the current price of a
  security reflects all available information. Only
  the arrival of new information will cause the
  price to change. And it asumes that succesive one
  period price changes are both independent and
  identically distributed (Fama 1970 p 383 390).
• Random Walk - stock prices are random
• Expected price is positive over time
• Positive trend and random about the trend

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Random Walk with Positive Trend
Security Prices
Time
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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
• It will only change if new information arises
• Successive price changes will be independent and
  prices follow a random walk cause the next piece
  of news will be independent of the last piece of
  news
• Shareholders are never sure whether the next item
  of relevant information is going to be good or
  bad.

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Competition as a source of Efficiency

• 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

Strong Form Efficiency
Semi-Strong Form Efficiency
Weak Form Efficiency
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Weak-form Efficiency

• It is based on forecast future by past returns.
  How well do past returns predict future returns?
  It is restricted only to historical prices. If
  market is weak-form efficient, it might not
  possible to obtain mispriced securities by
  analysing their past prices. Stock prices do
  follow a random walk.

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Semi-strong form Efficiency

• It is based on all publicly available information
  incorporated into stock prices to obtain profits
  in a stock market. How quickly do security prices
  reflect public information announcements? So it
  covers past price movements, earning and dividend
  announcements, right issues, technological
  breakthroughs, and so on. It indicates that it is
  not possible to outperform the market average
  return except by chance.

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Strong-Form Efficiency

• It is based on all publicly available
  information, reflected in stock prices. Do any
  investors have private information that is not
  fully reflected in market prices? It considers
  both public and private information and it
  focuses on insider dealing. According to
  strong-form even insiders are unable to obtain
  abnormal profits.

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Forms of the EMH-Briefly

• (a) Past prices Weak form.
• (b) All public information Semi-Strong Form. -
  past prices, news, etc.
• (c) All information including inside information
  Strong Form.

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The form of EMH-Evidence

• up to now, all of the study have shown that in a
  stock market there is a big probability to obtain
  efficient in the weak-form sense. Most of the
  evidence prove that it is possible to obtain
  semi-strong efficient in stock market even it is
  not easy as weak-form efficient. But many studies
  have shown that it is difficult to obtain strong
  form efficient in stock market.

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Supportive Evidence of EMH

• Weak form of EMH is supported by the
  data.-Source R. Brealey and S. Myers, Principles
  of Corporate Finance.
• Semi-strong form of EMH is generally supported by
  the data.-Source A. Keown and J. Pinkerton,
  Journal of Finance (1981).
• Strong-form of EMH has mixed evidence-Source M.
  Jensen, Risks, the Pricing of Capital Assets,
  and the Evaluation of Investment Performance.
  Journal of Business (April 1969).

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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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Active and passive Management

• Proponents of the EMH believe active management
  is largely wasted effort and unlikely to justify
  the expenses incurred. A passive strategy aims
  only at establishing a well-diversified portfolio
  of securities without attempting to find under or
  overvalued stock. Given all available
  information, the EMH indicates stock prices are
  at fair levels so that it makes no sense to buy
  and sell securities frequently as transactions
  generate large trading costs without increasing
  expected performance.

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Active and passive Management

• One common strategy for passive management is to
  create an index fund which is a fund designed to
  replicate the performance of a broad-based index
  of stocks
• i.e., a mutual fund called the index 500
  portfolio that holds stocks in direct proportion
  to their weight in the Standard Poors 500
  stock price index so the performance of the index
  500 fund replicates the performance of the SP
  500.

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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 Surrounding the Event
0
t
-t
Announcement Date
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How Tests Are Structured (cont.)

• 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 (cont.)

• 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

• To discuss empirical tests of hypothesis, the
  following factors should be taken into account
• Magnitude Issue
• Selection Bias Issue
• Lucky Event Issue

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Tests of Weak Form

• Returns over short horizons
• Very short time horizons small magnitude of
  positive trends
• 3-12 month some evidence of positive momentum
• Returns over long horizons pronounced negative
  correlation
• Evidence on Reversals

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Tests of Semi-strong Form Anomalies

• Small Firm Effect (January Effect)
• Neglected Firm
• Market to Book Ratios
• Post-Earnings Announcement Drift
• Higher Level Correlation in Security Prices

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Implications of Test Results

• Risk Premiums or market inefficiencies
• Anomalies or data mining
• Behavioral Interpretation
• Inefficiencies exist
• Caused by human behavior

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Behavioral Possibilities

• Forecasting Errors
• Overconfidence
• Regret avoidance
• Framing and mental accounting errors

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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

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Market Reaction

• In the figure, the red line shows an efficient
  market response to a car companys announcement
  of an electrical car. The share price on the
  vertical line instantaneously adjust to the new
  level. However, there are four other
  possibilities if we relax the the efficiency
  assumption. First, the market could take a long
  time to absorb this information i.e., under
  reaction and it could be only after the 30th day
  that the share price approaches the new
  efficiency level. This shown the area between 0
  and 30 days. Secondly, the market could
  anticipated the news announcement- Perhaps there
  have been leaks to press for the past to weeks.
  In this case, the share price starts to rise
  before the announcement. A third possibility is
  that the market overreacts to the new
  information the bubble deflates over the next
  few days. Finally, the market may fail to get the
  pricing right at all and shares may continue to
  be under-priced for a considerable period between
  0 and 30 days.

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Weak-form Efficiency
Exploiting predictable patterns in price movements
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Weak-form Efficiency

• Prices reflect anything past prices say about
  likely future prices.
• Predictable price movements unrelated to risk
  would be eliminated by investors buying at
  troughs and selling at peaks.

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Weak-form Efficiency
Pt Pt-1 Rt et , where Expected Return Rt
over (t-1,t) (excluding dividends), which Could
depend on past prices, but is known at t-1
while ?t Reflects New information after t-1, and
is uncorrelated with all functions of Pi, igt 0.
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Tests of weak-form efficiency
Recent work in financial economics has focused on
modeling predictable patterns in variances and
covariances (for example using the ARCH model).
These could be consistent with EMH if the
patterns are risky to exploit and the apparent
excess returns merely compensate for increased
risk.
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Tests of semistrong-form efficiency

• Pt Pt-1 equals the capital gain over the period
  (t1,t), and if dividends in (t1,t) are zero,
  then equation (1) becomes
• . Rt Rt ?t

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General formula
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Theory of Rational Expectations
Definition Rational expectation (RE)
Expectation that is optimal forecast (best
prediction of future) using all available
information i.e., RE ? Xe Xof Et X Wt

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Rational Expectations (cont)

• 2 reasons Expectations may not be rational
• Not best prediction
• Not using available information
• Rational expectation, although optimal
  prediction, may not be accurate
• Rational expectations makes sense because is
  costly not to have optimal forecast

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Rational Expectations (cont)

• Implications
• If there is a change in the way a variable moves,
  then the way expectations are formed also changes
• Forecast errors on average 0 and are not
  predictable

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Efficient Markets Hypothesis
Pt1 Pt C RET Pt Pet1 Pt
C RETe Pt Rational Expectations
implies Pet1 Poft1 ? RETe
RETof (1) Market equilibrium RETe RET (2)
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Efficient Markets Hypothesis
Put (1) and (2) together Efficient Markets
Hypothesis RETof RET
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Why the Efficient Markets Hypothesis makes sense

• If RETof gt RET ? Pt ?, RETof ?
• If RETof lt RET ? Pt ?, RETof ?
• until RETof RET
• Note
• All unexploited profit opportunities eliminated
• Efficient Market holds even if are uninformed,
  irrational participants in market

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Evidence on Efficient Markets Hypothesis

• Favorable Evidence
• Investment analysts and mutual funds dont beat
  the market
• Stock prices reflect publicly available
  information anticipated announcements dont
  affect stock price
• Stock prices and exchange rates close to random
  walk
• If predictions of ?P big, Rof gt R ? predictions
  of ?P small
• Technical analysis does not outperform market

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Evidence on Efficient Markets Hypothesis

• Unfavorable Evidence
• Small-firm effect small firms have abnormally
  high returns
• January effect high returns in January
• Market overreaction
• Excessive volatility
• Mean reversion
• New information is not always immediately
  incorporated into stock prices

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The End

• Thanks