Three Forms of Efficient Market Hypothesis by wqo19332

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									  Chapter 10

Market Efficiency
           Learning Objectives

• Explain the concept of efficient markets.
• Describe the three forms of market efficiency –
  weak, semi-strong, and strong
• Discuss the evidence regarding the Efficient
  Market Hypothesis.
• State the implications of market efficiency for
• Outline major exceptions to the Efficient Market
                  Efficient Markets

• How well markets respond to new information is a
  very important part of obtaining the equilibrium
  relationship predicted by the capital market theory
• Should it be possible to decide between a
  profitable and unprofitable investment given
  current information?
• Efficient Markets
     The prices of all securities quickly and fully reflect all
      available information
                    Efficient Markets
Definition of “all available information”
• All known information including:
      Past information (e.g., last year’s earnings)
      Current information as well as events that have been
       announced but are still forthcoming (e.g., stock splits
       and dividends)
• Information that can be reasonably inferred
      For example, if many investors believe that interest rates
       will decline soon, prices will reflect this belief before the
       actual decline occurs
      Conditions for an Efficient Market
Why the markets can be expected to be efficient?
• Large number of rational, profit-maximizing
     Actively participate in the market
     Individuals cannot affect market prices (i.e., price-
• Information is costless and widely available to
  market participants at approximately the same time
• Information is generated in a random fashion (e.g.,
  announcements or currency is devalued)
• Investors react quickly and fully to new information
  causing stock prices to adjust accordingly
 Consequences of Efficient Market

• Quick price adjustment in response to the
  arrival of random information makes the reward
  for analysis low
• Prices reflect all available information
• Price changes are independent of one another
  and move in a random fashion
     New information is independent of past
            Market Efficiency Forms
• Efficient market hypothesis (EMH)
     The proposition that securities markets are efficient,
      with prices of securities reflecting their true economic
• Three levels of Market Efficiency
     Weak form – prices reflect past market data (i.e.,
      historical price and volume information for stocks
      and indexes)
     Semi-strong form – prices reflect all public
     Strong form – prices reflect all information, both
      public and private
Cumulative Levels of Market Efficiency
 and the Information Associated with
                Strong Form
               All Information

             Semi-Strong Form
             Public Information

               Weak Form
               Market Data
                 Weak Form

• Prices reflect all past price and volume data
• Technical analysis, which relies on the past
  history of prices, is of little or no value in
  assessing future changes in price
• Market adjusts or incorporates this information
  quickly and fully
             Semi-Strong Form
• Prices reflect all publicly available information
• For example: earnings, dividends, stock split
  announcements, new product developments,
  financing difficulties, and accounting changes
• Investors cannot act on new public information
  after its announcement and expect to earn above-
  average, risk-adjusted returns
• Encompasses weak form as a subset since market
  data are part of the larger set of all publicly
  available information
                 Strong Form

• Prices reflect all information, public and private
• No group of investors should be able to earn
  abnormal rates of return by using publicly and
  privately available information
• Encompasses weak and semi-strong forms as
  subsets and represents the highest level of
  market efficiency
            Evidence on Market Efficiency
• Keys to testing the validity of any of the three
  forms of market efficiency
      Consistency of returns in excess of risk
      Length of time over which returns are earned
        •   Short-lived inefficiencies appearing on a random
            basis do not constitute evidence of market
            inefficiencies, at least in an economic sense
• Economically efficient markets
      Assets are priced so that investors cannot exploit
       any discrepancies and earn unusual returns
        •   Transaction costs matter
                   Weak-Form Evidence
Ways to test for weak-form efficiency
• Test for independence (randomness) of stock price
  changes [Random Walk Hypothesis]
      If stock prices are independent, trends in price
       changes do not exist
        •    Knowing and using the past sequence of price
            information is of no value to an investor
• Test for profitability of trading rules after brokerage
      Simple buy-and-hold better
        •    Buying a portfolio of stocks and holding it until a
            common liquidation date
                    Weak-Form EMH
• Stock price changes in an efficient market should be
• Statistical tests of price changes are mostly supportive
  of weak-form EMH
• The sign test involves classifying each price change by
  its sign, which means whether it was +, 0, or –
• Then the “runs” in the series of signs can be counted
  and compared to known information about a random
• Runs tests
      •   looking for patterns in signs of returns
      •   i.e. + + - + - +
                   Weak-Form EMH
• The signs test supports independence of stock price
• Although some runs do occur, they fall within the limits
  of randomness since a truly random series will exhibit
  some runs
• Technical trading rules
      •   Technical analysts believe that trends not only exist
          but can also be used successfully
      •   Little evidence exists that technical trading, based
          solely on past price and volume data, can outperform
          a simple buy-and-hold strategy
   Two Apparent Contradictions to the
           Weak-Form EMH
1. Momentum or persistence in stock returns
     tendency of stocks that have done well over the
      past 6 to 12 months to continue to do well over the
      next 6 to 12 months
2. “Contrarian” Strategies
     Overreaction Hypothesis [DeBondt & Thaler
     stocks that have done well over the past 3-5 year
      period, will do poorly over the subsequent 3-5 year
     Two Apparent Contradictions to
          the Weak-Form EMH
• Contrarian strategies are trading strategies
  designed to exploit the overreaction hypothesis
• Since the underlying rationale is to purchase or sell
  stock in anticipation of achieving future results that
  are contrary to their past performance record
• DeBondt and Thaler are testing whether the
  overreaction hypothesis is predictive
• In other words, knowing past stock returns appears
  to help significantly in predicting future stock
           Semi-Strong-Form Evidence
• Event studies
     Empirical analysis of stock price behaviour
      surrounding a particular event
     Usually use an index model of stock returns such as
      single-index model
     Examine company unique returns
       •   The residual error between the security’s actual return
           (Rit ) and that given by the index model E(Rit)
       •   Abnormal return (Arit) = Rit - E(Rit)
       •   Cumulative abnormal return (CAR) = Σ Arit

       CAR is the sum of the individual abnormal returns over
        the period of time under examination
       Semi-Strong-Form Evidence
• Stock splits                      • Initial public offerings
      (Fig 10.4 pg 281)                  Only issues purchased
       Implications of split               at offer price yield
       reflected in price                  abnormal returns
       immediately following              This is attributed to
       the announcement and                underpricing by the
       not the event itself                underwriters
• Accounting changes                • Announcements and
      Quick reaction to real         news
       change in economic                 Little impact on price
       value (e.g., depreciation,          after release
       inventory reporting [LIFO
                                          Involving economic news
       vs. FIFO])
                                           (e.g., inflation or Bank of
                                           Canada rate)
   Professional Portfolio Manager
• There is substantial evidence that portfolio
  managers do not outperform the market (or earn
  abnormal risk-adjusted returns) over the long
• The average active portfolio manager may
  underperform the market index by 50 to 200
  basis points
• Based on fund averages (US-based equity
  mutual funds & pension funds)
             Strong-Form Evidence
• Test performance of groups which have access to
  nonpublic (private) information
     Corporate insiders have valuable private
     A corporate insider is an officer, director, or major
      stockholder of a corporation who might be expected
      to have valuable inside information
     Evidence that many have consistently earned
      abnormal returns on their stock transactions
      (strong-form efficiency is not supported)
• Insider transactions must be publicly reported
  (OSC requires reporting y the tenth day of the next
       Implications of Efficient Market
• What should investors do if markets are
• 1- Technical analysis
     Not valuable if weak-form holds
     The evidence accumulated to date
      overwhelmingly favors the weak-form EMH and
      casts doubt on technical analysis
      Implications of Efficient Market
• 2- Fundamental analysis
     Seeks to estimate the intrinsic value of a
     Not valuable if semi-strong-form holds (since
      stock prices reflect all relevant publicly available
      information, gaining access to information
      others already have is of no value)
     EMH suggests that investors who use the same
      data and make the same interpretations as
      other investors will experience average results
      Implications of Efficient Market
• 3- Money Management
• For professional money managers (assuming that
  the market is efficient)
     Less time spent on assessing individual securities
       •   Passive investing favored (one passive investment
           strategy that is becoming increasingly popular is
           indexing, which involves the construction of portfolios
           designed to mimic the performance of a chosen
           market benchmark portfolio, such as S&P/TSX
           Composite Index)
       •   Otherwise, must believe in superior insight
  Implications of Efficient Market

• 3- Money Management
     Tasks that portfolio managers have to perform
      if markets are informationally efficient
       •   Maintain correct amount of diversification
       •   Achieve and maintain a desired level of
           portfolio risk
       •   Manage tax burden
       •   Control transaction costs (can be done through
           index funds)
           Market Anomalies

• Exceptions (techniques or strategies) that
  appear to be contrary to market efficiency
• Regardless of how persuasive the case for
  market efficiency is, debate of this issue id
  likely to persist
                Market Anomalies

• Size effect
   Tendency for small firms to have higher risk-
    adjusted returns than large firms
   Market betas could not account for the abnormal
   Bid-ask spreads, which are higher for smaller
    stocks, could not account for the abnormal returns
  As a result, when trading on the TSX, the small-firm
    strategy may be a viable strategy for increasing
    portfolio returns without an offsetting increase in risk
                 Market Anomalies
Seasonality in stock returns
• January effect
     Tendency for small firm stock returns to be higher in
     Of the 30.5% small-size premium, half of the effect
      occurs in January
     Referred to as “the small firm in January effect”
      because it is most prevalent for the returns of small-
      cap stocks
     More than half of the excess January returns
      occurred during the first five trading days of that
                 Market Anomalies
Seasonality in stock returns
• Day-of-the-week effect
     The average Monday return is negative and
      significantly different from the average return of the
      other four days
• Day-of-the-month effect
     Returns tend to be higher on the last trading day of
      each month
         Conclusions about Market
• Support for market efficiency is persuasive
      Much research using different methods
      Also many anomalies that cannot be explained
• Markets are quite efficient, but not totally
      To outperform the market, superior
       fundamental analysis (beyond the norm) must
       be done
      The fundamental analysis that is done
       everyday is already reflected in stock prices
          Conclusions about Market
• If markets are operationally efficient, some
  investors with the skill to detect a divergence
  between price and semi-strong value (price based
  on all available public information) earn profits
     Excludes the majority of investors
     Anomalies offer opportunities
• Controversy about the degree of market efficiency
  still remains
• The evidence to date suggests that investors face
  an operationally efficient market

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