Efficient Markets(1)

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					                             Further Notes on Efficient Markets


                                              Ali M. Reza

Efficiency in economics refers to consumer utility efficiency; it is a situation where you
cannot make one consumer better off without making someone else worse off. One step
removed from consumers, we can talk about “productive” efficiency, a state when output
(of desirable products) cannot increase without lessening the output of another desirable

In finance a market is efficient if it is informationally efficient. This means that prices
incorporate all of the relevant information. Roughly speaking it says this: prices are the
result of decisions made by individual investors; prices therefore reflect the information
used to arrive at those decisions. An implication of this is that one cannot earn superior
returns using the same information that the market possesses. It also means that the future
returns will largely depend not on the information currently in the market, but on new
information that will come into the market. New information is called “news”. How does
news arrive? In a random fashion – no-one can predict what news will arrive and when;
that is the nature of news – otherwise it would not be news! Note then that an investor
whose information is the same as the information that is already in the market and who is
unable to predict “news” is also unable to outperform the market.

To talk about market efficiency we must be explicit about the information set which the
market uses to form investor expectations. Eugene Fama proposed three possibilities:

   1. Weak Form Efficiency (or Weakly Efficient): A market is weak form efficient if
      all past prices are considered:

               …., Pt-3, P t-2, P t-1 , P t

       This means that the tomorrow’s price incorporates the current and all the past
       prices. In other words, any impact current and past prices have is reflected in the
       expectation about future price.

   2. Semi-Strong Efficiency (or Semi-strongly Efficient): A market is semi-strong
      form efficient is all if all publicly available information (including current and
      past prices) is used to form the expectation about future price. This means that
      stock volumes and things such as the firm’s financial reports and plans that are
      public, sales, P/E ratio, and so on – anything and everything that is in the public
      domain – is used by investors to form their view of the future price. Note that
      since current and past prices are included in semi-strong efficiency, then weak
      form is a subset of semi-strong form. It should be noted that some (few) authors
      include volume as a second set included in the Weak Form efficiency – so be
      careful on this.

   3. Strong Form Efficiency (or Strongly Efficient): A market is strongly efficient if
      all information, private and public, is used by investors to form expectation about
      the future price. This means that even when a firm decides to buy another firm but
      that information is not yet divulged, still that fact is taken into account by the
      market and expectations of future price reflect that fact. The explanation offered
      is that individuals privy to the information will somehow let the secret out –
      mostly through their actions – so that the market price will reflect that

The empirical evidence in support of the Weak Form Efficiency is quite strong (although
some contrary evidence has been reported). The evidence in support of the Semi-Strong
Form is substantial but not as strong as the evidence that supports Weakly Efficient
markets. Most of the evidence refutes the Strong Form efficiency.

There are competent studies that provide evidence that one can use only past prices to
beat the market. However, the difference between such policies and the buy-and-hold
policy is so small that transaction costs make such policies unprofitable.

This is how things presumably work. There is intense competition in the capital markets,
with each investor attempting to outdo the others. To beat others (i.e., beat the market –
where beating the market means earning a higher risk-adjusted return on your
investment in selected stocks than merely investing in the entire market without
attempting to time the market – which is buy and hold the market) there are two
requirements: (a) your forecast be accurate, and (b) your forecast be different from other
investors’ forecasts. So investors use all the relevant information they can obtain. Note
that this does not rule out the possibility that someone who has superior forecasting and
analytical ability cannot beat the market – if you think you can forecast the future better
than other investors and your forecast is different, then you may earn higher risk-adjusted
returns than others (i.e., beat the market). The view held by financial economists is that
the number of investors is so large (in the millions) with the number of professionals is
similarly large (in the thousands, at least), and all have access to the same information,
that it is extremely difficult to make forecasts that are both accurate and different from

With respect to Weak Efficiency the information is merely past data: it is pretty easy for
all to come to the same (or nearly the same) conclusion what these past prices mean and
imply for the future. When it comes to Semi-Strong Efficiency, with all sorts of data and
information, there is more room for forecasts to differ – hence there may well be room
for beating the market sometimes. When it comes to Strong Efficiency, the information
may not be available to all participants, providing a good deal of opportunity to beat the
market (perhaps!).

Consider when a firm decides to buy another company but this decision is kept from the
market. Generally when a company buys another, and after the information becomes
public, the share price of the buyer drops and the share price of the seller rises. As long as

this information is kept secret, there should be no price impact. However, in various
studies (called “event’” studies), it is observed that the share price of the seller starts to
rise many days (or weeks) before this decision is made public officially – suggesting that
the information leaks. That is why some hold the view that even private information
cannot be used to beat the market. Or consider the case where a worker drilling for oil for
an oil company notices traces of oil-soaked dirt coming up through the drilling pipes.
Will the worker first call his broker or his foreman? And suppose the worker informs his
foreman; will the latter now call her broker? The same story continues all the way up the
chain of command. This presumably private information is very likely to go into the
market not much later than (if not before!) it reaches the CEO.

One rationale behind the Efficiency (Weak Form or otherwise) hypothesis is this:
suppose some news arrives in the market which provides an opportunity to earn a higher-
than-required risk-adjusted return – this is called an “unexploited profit opportunity”. All
the Efficiency hypothesis says is that as soon as such opportunities arise, investors
eliminate them. For example, if the news is good for the stock and its price should be
higher as a result, investors would pour lots of money buying the stock and therefore
pushing the price up in a very short period of time. In the theoretical extreme, price rises
instantaneously leaving no opportunity for anyone: Imagine that the price of stock XYZ
sits as (the equilibrium of) $25 and a bit of news arrives so that equilibrium price should
now be $30; you place an order to buy the stock and so do lots of others. The pressure of
demand will push the stock up almost immediately to $30 – because only at this price
demand and supply are in equilibrium.

Of course, the capital market is not as perfect as implied in the above paragraph. If that
were so it wouldn’t pay for anyone to analyze securities – which would cause the failure
of the market! In reality the market is just imperfect (or inefficient) enough that makes it
possible for investors to spend resources to analyze the market/securities. But the
imperfection is small enough that all these analysts can earn is a “normal” risk-adjusted
rate of return on their investment in analytical resources (this is a problem in capital
budgeting from principles of finance).

We can test for Weak Efficiency in several ways. The easiest and most popular if the
following: since past prices cannot predict the next period’s price change (under Weak
Efficiency), then one period’s price change should be uncorrelated with the next period’s
price change (indeed one period’s price change should be uncorrelated with any other
period’s price change, past or future). So the test is the simple test of whether one
observes correlations between changes in price over time. The results of such tests tend to
support Weak Efficiency.

Incidentally, this is a consequence of the random walk model: next period’s price level is
equal to the previous period’s price level, plus a random term. This random term itself is
assumed to be normally distributed with a mean μ and a variance V. The mean μ
represents the long term trend in the stock price, where μ can be zero (no trend), positive
(rising) or negative (falling). Note that with the random walk model of price
determination we can predict all future prices: they are all equal to the current price, plus

the mean value μ (the trend) [Note: if the mean for 1 day is μ then for a forecast of 2 days
out you should use 2 μ, for 3 days 3 μ, and so on].

Other evidence in support of the Weak Form efficiency: mutual funds/investment
advisors on average do not beat the market – indeed they fall short of the market return
by about the amount of the fund’s expense. Furthermore, having performed well in the
past does not predict the future performance of a mutual fund/investment advisors. At
least in part, this is the reason for the popularity of passive index funds investment as
well as the recent popularity of ETFs. And, all technical analytic methods that are in the
public domain fail to beat the market, on average.


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