emhlect1

8/3/2019 emhlect1

1/37

Efficient Market

HypothesisFaisal Meer

8/3/2019 emhlect1

2/37

Learning Objectives

After this lecture, the associated readings and seminar

work, you should have developed a basic knowledge of:

The role of randomness and luck investmentperformance.

The Efficient Market Hypothesis (EMH)The Three Forms of Market EfficiencyThe Various Tests of Market Efficiency

8/3/2019 emhlect1

3/37

Short-term Speculation:

Good, or Lucky?

A coin-flipping contest6 billion people pay $1 each to joinHeads you stay in, tails you are out

After one round, 3 billion are still inAfter ten rounds, about 6 million are still in

Imagine, flipping 10 heads in a row.

People begin to believe they are good at flipping, not lucky.After 20 rounds, around 6,000 people leftLocals become heroes!But half of these falter in the next round

After 25 rounds, 180 flippers are remainIf the game stopped now, each would receive $33.3 millionThese people write books about their technique and strategy

8/3/2019 emhlect1

4/37

After the 30 round, only 6 remain thEach would get $1 billion if the game stopped

It would probably take 32 rounds to end with a singlewinner

The odds of flipping heads 32 times in a row isroughly one in six billion.Is the winner good at flipping? Lucky?

There are millions of investors, analysts, portfolio managers,advisors, etc. participating in the investment process.

Many will appear to be top performers (at least for theshort-term)Who is lucky and who is good? How can you tell?

8/3/2019 emhlect1

5/37

We Always Come Back to NPV

Remember that a good financing decision generates a positiveNPV. It is one in which the amount of cash raised exceeds thevalue of the liability created.If selling a security generates a positive NPV for the seller, itmust generate a negative NPV for the buyer.What are the chances that your firm could consistently trickor persuade investors into purchasing securities with negative

NPV to them? Pretty Low!In general, firms should assume that the securities they issueare fairly priced.

8/3/2019 emhlect1

6/37

Three Types of Efficiency

Allocational Efficiency: Market channels funds tothose firms and institutions with the most promisingreal investment opportunities.Operational Efficiency: Buyers and sellers ofsecurities can purchase transaction services at prices

that are as low as possible given the costs associatedwith having these services provided.Pricing Efficiency: The investor can expect to earnmerely a risk adjusted return from an investment as

prices move instantaneously and in an unbiased mannerto any news.

8/3/2019 emhlect1

7/37

Definitions of Market Efficiency

A securities market is efficient if security pricesfully reflect the information available.(Fama 1970)

The market is efficient with respect to somespecified information system, if and only ifsecurity prices act as if everyone observes theinformation. (Beaver 1989)

8/3/2019 emhlect1

8/37

Market EfficiencyThe price for any given stock is effectively fair

= the expected net present value of all future profitsDiscounted using a fair risk-adjusted return

NeedLarge number of buyers and sellersFree and readily available informationEssentially identical securitiesUninhibited trading

If there are bargains available, investors would bid up theprice buying those stocks until the stock is no longer abargain.

If markets are efficient, then it would be difficult for aninvestor to consistently beat the market.

8/3/2019 emhlect1

9/37

Why is Market Efficiency Important?

The more efficient the market, the easier it isto transfer idle funds to those parties that needthe funds.If funds remain idle, this results in lower

growth for the economy and higherunemployment.Investors can adjust their portfolios easilyand at low cost as their needs and preferences

change. 9

8/3/2019 emhlect1

10/37

Why is Market Efficiency Important?

To Encourage Share Buying: Investors need to know that

they are paying a fair price and that they will be able to sellat a fair price.

To Give Signals to Company Managers: Managers, inpursuit of maximizing shareholders wealth, need to get

feedback on their decisions.

Share prices signal the rate of return investors demand onsecurities of a particular risk.

To Help Allocate Resources: Allocational Efficiencyrequires both operating and pricing efficiency.

8/3/2019 emhlect1

11/37

Information and Price Movements

The Efficient Market Hypothesis (EMH)

In an efficient capital market, prices reflect all availableinformation.When new information arrives, prices react instantaneously to it.Since new information is that which cannot be predicted, itwould arrive at random points in time.

Price movements are random (i.e. cannot be predicted).The EMH implies that if new information is revealed about afirm it will be incorporated into the share price rapidly andrationally, with respect to the direction of the share pricemovement and the size of that movement.

8/3/2019 emhlect1

12/37

Random Walk Theory

The movement of stock prices from day to day DO NOT

reflect any pattern.

Statistically speaking, the movement of stock prices israndom (skewed positive over the long term).

(A Chance Discovery in 1953 by Maurice Kendall, a BritishStatistician who presented a controversial paper to the RoyalStatistical Society on the behavior of stock and commodity

prices. Kendall had expected to find regular cycles, but to his

surprise, he observed that the prices of stocks andcommodities seemed to follow a random walk).

8/3/2019 emhlect1

13/37

Random Walk With Positive Trend

Security

PricesTime

8/3/2019 emhlect1

14/37

Random Walk Theory

Why are price changes random?

Prices react to information

Flow of information is random

Therefore, price changes are random

8/3/2019 emhlect1

15/37

Types of Stock Analysis

Technical AnalystsForecast stock prices based on thewatching the fluctuations in historicalprices (thus wiggle watchers ). wiggle watchers

Fundamental AnalystsResearch the value of stocksusing NPV and other measurementsof cash flow.

8/3/2019 emhlect1

16/37

Versions of the EMH

All information

relevant to a stockInformation set

of publicly availableinformation

Information

set ofpast prices

8/3/2019 emhlect1

17/37

Three Forms of Market Efficiency Hypothesis

Weak Form Efficient MarketMarket prices reflect all historical information .Random Walk

Semi-strong Form Efficient Market

Market Prices reflect publicly available

informationStrong Form Efficient Market

Market prices reflect all information, bothpublic and private.

i i f ffi i

8/3/2019 emhlect1

18/37

Empirical Tests of Market Efficiency

Testing some trading rule

Event studies

Assessing performance of professionalmanagers

W k F T

8/3/2019 emhlect1

19/37

Weak Form Tests

A Simple Price ChartTechniques used by Technical Analysts (orChartists) to identify patterns in shares:The Head and Shoulders Pattern

The Filter ApproachThe Dow Theory (Primary-Long-term,Intermediate-weeks/months, Tertiary Trends-fewdays)

Other Strategies

W k F T t E id

8/3/2019 emhlect1

20/37

Weak-Form Tests: Evidence

Overwhelmingly the evidence and the weight ofacademic opinion is that the Weak-Form of theEMH is to be accepted.The history of share prices cannot be used to

predict the future in any abnormally profitableway.But still there is some evidence that puts theabove conclusions into doubt (e.g., De Bondt and

Thaler 1985)

S i St F T t

8/3/2019 emhlect1

21/37

Semi-Strong Form Tests

Focuses on the question of whether it isworthwhile expensively acquiring and analysingpublicly available information.Fundamental Analysts try to estimate (based on

available information) shares true value based onfuture returns.These are then compared with the market price toestablish over-or undervaluation.

Semi Strong Form Tests

8/3/2019 emhlect1

22/37


(Information Announcements)

Investigating whether trading in sharesimmediately following announcements of newinformation (e.g., earnings, dividend, stock splits

etc) could produce abnormal returns.

Generally the evidence supports the EMH, as noexcess returns are found in most of the studies.

Semi Strong Form Tests

8/3/2019 emhlect1

23/37


(Information Announcements)

Ball and Brown (1968) studied the averagefirms response to annual earnings.Efficiency and Anomaly:

Most of the price reaction is completed

immediately after earnings are announced. Thereis little delay in the reaction, so there is littleopportunity to earn abnormal returns from themarket systematically erring in its response to the

announcement.Post Announcement Drift

Semi Strong Form Tests: Evidence

8/3/2019 emhlect1

24/37

Semi-Strong Form Tests: Evidence

A study by Patell and Wolfson (1984) shows justhow fast prices move when new informationbecomes available.They found that, when firms publishes its latestearnings or announces a dividend change, themajor part of the adjustment in price occurswithin 5 to 10 minutes of the announcement.


8/3/2019 emhlect1

25/37

Semi-Strong Form Tests: EvidenceExample: How stock splits affect value

A firm may split its shares by increasing thenumber of shares of common and reducing thepar or stated value per share in the proportion.Study by Fama, Fisher, Jensen, and Roll (1969)investigate Stock Split or Bonus Issues.


8/3/2019 emhlect1

26/37

Semi Strong Form Tests: EvidenceExample: How stock splits affect value

Lets assume a firm has outstanding one millionshares of 10 par value stock.The market price is 90 per share.The firm issues one Bonus Share for everyexisting share owned by investors. (par 5)As a consequence, the number of shares in issuewill increase to two million.


8/3/2019 emhlect1

27/37


A shareholder who owned 100 shares before the bonus share issue

would now own 200 shares after the issue.Since this has no effect on the future cash flows, one would expectthe share price before the Bonus Issue to be Twice its value after theBonus Issue.,Based on this, Fama et al. argue that there should be no market

reaction to Bonus Issues/Stock Splits announcements.Alternatively, if Bonus Issues are used as a signal that there has

been a permanent increase in firms cash flows, then there might besome market reaction.Using Market Model, Fama et al. estimate Beta for each security.


8/3/2019 emhlect1

28/37


Calculated the cumulative average residual overthe period 29 months prior to the Bonus Issue and30 months after the IssueFama et al. report that share prices rise by anabnormal amount relative to the share marketprior to Split.

(See the Chart on the next slide).


8/3/2019 emhlect1

29/37

gExample: How stock splits affect value

There has been a market reaction to a purelypaper issuing exercise (i.e., Bonus Issue).Recall the Signalling argument that suggeststhat Bonus Issues are used to signal a permanentincrease in cash flows.Consider implications in terms of DividendPayout to shareholders.


8/3/2019 emhlect1

30/37


Assuming a 30p Dividend Payout per share, Whatwould be the implications if:Dividend Rate is maintained?Doubling of the Dividend Payout to 60pIt Cuts the Dividend Rate to 15p?Maintaining the Dividend Payout.If Dividend Rate is Dropped Below 15p.Reducing total Dividend Payout.


8/3/2019 emhlect1

31/37


To investigate this issue, Fama et al. Split theirsample into two:

Firms which had increased the Dividend PayoutAfter the Bonus Issue.

Firms which had decreased the Dividend PayoutAfter the Bonus Issue.


8/3/2019 emhlect1

32/37


Fama et al. repot that there is no net movement

up or down in the cumulative average residuals(i.e., abnormal returns).

This implies that on the average the marketmakes unbiased dividend forecasts for splitsecurities and these forecasts are fully reflectedin the price of the security by the end of the splitperiod.

Semi-Strong Form Tests:

8/3/2019 emhlect1

33/37

Summary of Evidence

The evidence for Semi-Strong Efficiency issignificant but not overwhelming as that of WeakForm Efficiency.The market needs speculators and long-term

investors continually on the search for under-or-overpriced securities.It is through their buying and selling activitiesthat inefficiencies are minimized and the market

is a fair game.

Strong-Form Tests: Evidence

8/3/2019 emhlect1

34/37

g

Tests of the strong Form of the Hypothesis haveexamined the recommendations of professionalsecurity analysts and have looked for mutualfunds or pension funds that could predictablyoutperform the market.

Some researchers have found a slight consistentoutperformance, but just as many have concludedthat professionally managed funds fail to recoupthe costs of management.


8/3/2019 emhlect1

35/37

A study of 1493 US mutual funds by MarkCarhart (1997) reveals that in some years themutual funds beat the market, but as often not asit was the other way around.Each fund is compared with a benchmark

portfolio of similar securities.The funds earned a lower return than the

benchmark portfolios after expenses, and roughlymatched the benchmarks before expenses.


8/3/2019 emhlect1

36/37

Evidence on Insiders informational advantageInsider dealing:Is it a Robbery?Is Insider destroying investors confidence?

References

8/3/2019 emhlect1

37/37

Bodie, Z., A. Kane, and A. J. Marcus(2007), Essentials of Investments.

Hirschey, M., and J. R. Nofsinger (2008),Investments: Analysis and Behavior,McGraw-Hill.

emhlect1

Documents

Transcript of emhlect1