The Efficient Market Hypothesis Department of Banking and Finance SPRING 200 7 -0 8 by Asst. Prof....

The Efficient Market Hypothesis

Department of Banking and Finance

SPRING 2007-08

by

Asst. Prof. Sami Fethi

2 Investment Management © 2005, Sami Fethi, EMU, All Right Reserved.

Ch 8: EMH

Efficient Market Hypothesis (EMH)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.


Ch 8: EMH

Efficient Market Hypothesis (EMH)-DefinitionEfficient 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 company’s shares (or the financial securities, such as bonds), rapidly and correctly reflects all relevant information as it becomes available (Lumby 1992:352).


Ch 8: EMH

Efficient Market Hypothesis (EMH)-DefinitionEfficient 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.


Ch 8: EMH

Random Walk and the EMHRandom 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 timePositive trend and random about the trend


Ch 8: EMH

Security Security PricesPrices

TimeTime

Random Walk with Positive TrendRandom Walk with Positive Trend


Ch 8: EMH

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.

Random Price ChangesRandom Price Changes


Ch 8: EMH

Competition as a source of EfficiencyCompetition 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


Ch 8: EMH

Forms of the EMHForms of the EMH Weak Semi-strong Strong

Strong Form

Efficiency

Semi-Strong Form Efficiency

Weak Form Efficiency


Ch 8: EMH

Weak-form EfficiencyWeak-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.


Ch 8: EMH

Semi-strong form EfficiencySemi-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.


Ch 8: EMH

Strong-Form EfficiencyStrong-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.


Ch 8: EMH

Forms of the EMH-BrieflyForms 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.


Ch 8: EMH

The form of EMH-EvidenceThe 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.


Ch 8: EMH

Supportive Evidence of EMHSupportive 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).


Ch 8: EMH

Types of Stock AnalysisTypes 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


Ch 8: EMH

Active Management– Security analysis– Timing

Passive Management– Buy and Hold– Index Funds

Implications of Efficiency for Active or Implications of Efficiency for Active or Passive ManagementPassive Management


Ch 8: EMH

Active and passive ManagementActive 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.


Ch 8: EMH

Active and passive ManagementActive 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 & Poor’s 500 stock price index so the performance of the index 500 fund replicates the performance of the S&P 500.


Ch 8: EMH

Even if the market is efficient, a role exists for portfolio management

Appropriate risk level Tax considerations Other considerations

Market Efficiency and Portfolio Market Efficiency and Portfolio ManagementManagement


Ch 8: EMH

Event studiesAssessing performance of professional

managersTesting some trading rule

Empirical Tests of Market EfficiencyEmpirical Tests of Market Efficiency


Ch 8: EMH

1. Examine prices and returns over time

How Tests Are StructuredHow Tests Are Structured


Ch 8: EMH

00 +t+t-t-t

Announcement DateAnnouncement Date

Returns Surrounding the Event


Ch 8: EMH

2. Returns are adjusted to determine if they are abnormalMarket Model approach

a. Rt = at + btRmt + et

(Expected Return)

b. Excess Return = (Actual - Expected)

et = Actual - (at + btRmt)

How Tests Are Structured (cont.)How Tests Are Structured (cont.)


Ch 8: EMH

2. Returns are adjusted to determine if they are abnormalMarket Model approach

c. Cumulate the excess returns over time:

00 +t+t-t-t

How Tests Are Structured (cont.)How Tests Are Structured (cont.)


Ch 8: EMH

To discuss empirical tests of hypothesis, the following factors should be taken into account:

Magnitude IssueSelection Bias IssueLucky Event Issue

Issues in Examining the ResultsIssues in Examining the Results


Ch 8: EMH

Tests of Weak FormTests 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


Ch 8: EMH

Small Firm Effect (January Effect)Neglected FirmMarket to Book RatiosPost-Earnings Announcement DriftHigher Level Correlation in Security Prices

Tests of Semi-strong Form: AnomaliesTests of Semi-strong Form: Anomalies


Ch 8: EMH

Implications of Test ResultsImplications of Test Results

Risk Premiums or market inefficienciesAnomalies or data miningBehavioral Interpretation

– Inefficiencies exist– Caused by human behavior


Ch 8: EMH

Behavioral PossibilitiesBehavioral Possibilities

Forecasting ErrorsOverconfidenceRegret avoidanceFraming and mental accounting errors


Ch 8: EMH

Mutual Fund and Professional Manager Mutual Fund and Professional Manager PerformancePerformance

Some evidence of persistent positive and negative performance

Potential measurement error for benchmark returns– Style changes– May be risk premiums

Superstar phenomenon


Ch 8: EMH


Ch 8: EMH

Market ReactionMarket Reaction In the figure, the red line shows an efficient market response

to a car company’s 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.


Ch 8: EMH

Weak-form Efficiency

Exploiting predictable patterns in price movements


Ch 8: EMH


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.


Ch 8: EMH


Pt =Pt-1 – Rt εt , where

Expected Return Rt over (t-1,t) (excluding dividends), which Could depend on past prices, but is known at t-1; while

εt Reflects New information after t-1, and is uncorrelated with all functions of P–i, i> 0.


Ch 8: EMH

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.


Ch 8: EMH

Tests of semistrong-form efficiency

Pt – Pt-1 equals the capital gain over the period (t–1,t), and if dividends in (t–1,t) are zero, then equation (1) becomes:

. Rt =Rt +εt


Ch 8: EMH

General formulaGeneral formula


Ch 8: EMH

Theory of Rational ExpectationsTheory 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 | t ]


Ch 8: EMH

Rational Expectations (cont…)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


Ch 8: EMH

Rational Expectations (cont…)Rational Expectations (cont…)

Implications:

1. If there is a change in the way a variable moves, then the way expectations are formed also changes

2. Forecast errors on average = 0 and are not predictable


Ch 8: EMH

Efficient Markets HypothesisEfficient Markets Hypothesis

Pt+1

– Pt + C

RET =P

t

Pet+1

– Pt + C

RETe =P

t

Rational Expectations implies:

Pet+1

= Poft+1

RETe = RETof (1)

Market equilibrium

RETe = RET* (2)


Ch 8: EMH

Efficient Markets HypothesisEfficient Markets Hypothesis

Put (1) and (2) together:

Efficient Markets Hypothesis

RETof = RET*


Ch 8: EMH

Why the Efficient Markets Hypothesis Why the Efficient Markets Hypothesis makes sensemakes sense

If RETof > RET* Pt , RETof

If RETof < RET* Pt , RETof

until RETof = RET*Note:1. All unexploited profit opportunities eliminated

2. Efficient Market holds even if are uninformed, irrational participants in market


Ch 8: EMH

Evidence on Efficient Markets HypothesisEvidence on Efficient Markets Hypothesis

Favorable Evidence

1. Investment analysts and mutual funds don’t beat the market

2. Stock prices reflect publicly available information: anticipated announcements don’t affect stock price

3. Stock prices and exchange rates close to random walk

If predictions of P big, Rof > R* predictions of P small

4. Technical analysis does not outperform market


Ch 8: EMH

Evidence on Efficient Markets Evidence on Efficient Markets HypothesisHypothesis

Unfavorable Evidence

1. Small-firm effect: small firms have abnormally high returns

2. January effect: high returns in January

3. Market overreaction

4. Excessive volatility

5. Mean reversion

6. New information is not always immediately incorporated into stock prices


Ch 8: EMH

The EndThe End

Thanks

The Efficient Market Hypothesis Department of Banking and Finance SPRING 200 7 -0 8 by Asst. Prof....

Documents

Transcript of The Efficient Market Hypothesis Department of Banking and Finance SPRING 200 7 -0 8 by Asst. Prof....