Efficient-market Hypothesis · 2004-06-15 · Efficient-market Hypothesis
The Essentials of an Efficient Market - Final
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Transcript of The Essentials of an Efficient Market - Final
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The Essentials of An Efficient Market and Implications for Investors, Firms and Regulators
Presented BySam Mensah, Ph.D SEM Financial Group/African Capital Markets Forum, Ghana
UNECA Workshop on African Capital Markets Development27-29 October, 2003, Johannesburg, SA
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Market Efficiency Concepts
Allocation Efficiency Does capital flow to the projects with the highest
risk-adjusted returns?
Operational Efficiency Are transactions completed on a timely basis,
accurately and at low cost?
Informational Efficiency Does the observed market price of a security reflect
all information relevant to pricing the security?
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Theory of Efficient Markets
Financial economics focuses on informational efficiencyAn efficient market is a market that is
efficient in processing informationPrices of securities observed at any point in
time are based on a correct evaluation all information available at the time, i.e. prices “fully reflect” all available information
Also called “Efficient Markets Hypothesis (EMH)”
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Patterns of Market Response
Early Response (anticipated information)Efficient Markets ResponseDelayed Response and ReversionOverreaction
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Why do we need to appreciate EMH?
Fundamental attributes of a capitalist economy Prices are accurate signals for capital allocation Both issuers and buyers of securities expect fair prices Persistence of glaring pricing anomalies erodes market
confidence Examples of pricing anomalies are common on African markets
Share prices unchanged on ex-dividends or ex-rights Share prices remain unchanged after new information is released
African capital markets will not develop unless both issuers and investors believe that securities are fairly priced
Market regulators, policymakers and operators need to focus on improving pricing efficiency
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Economic Foundations of the EMH
EMH is an applications the theory of rational expectations to financial markets
A set of postulates are advanced to justify the EMH
Expectations of future returns are rational, i.e. equal to the optimal forecasts on the basis of the best available information
On average, the expected return will equal the equilibrium return, i.e. the return based on factors such as risk, liquidity, etc
Current prices will be set such that the optimal forecast of a security’s return using all available information will be equal to the security’s equilibrium return
In an efficient market, all unexploited profit opportunities will be eliminated Stock prices follow a “random walk”, i.e. future changes in prices should for all
practical purposes be unpredictable Persistence of inefficiency means that investors are not using all
information at their disposal in setting security prices, i.e. expectations are not “rational”
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What is the Empirical Evidence?
Whether markets are efficient or indeed can be efficient has not been fully resolved
Extensive testing has taken place in advanced markets
Research on the efficiency of African capital markets is scanty
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Tests in Advanced Markets Tests generally support weak-form efficiency (i.e.
past prices cannot be used to predict future prices) Public information has been found to incorporated
into and sometimes even anticipated by prices, therefore markets are strong-form efficient
Few portfolio managers are able to beat the market and do not do so with any consistency
But insiders are able to earn above normal returns securities
markets are inefficient at the strong-form level
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The African Evidence
Kofi Osei, 1998) found that stock prices in Ghana did not conform to random walk hypothesis, therefore market was weak-form inefficient
Addo (2001) tested ex-dividend day adjustment; statistically significant price appreciation on ex-dividend
day, contrary to theory Market is weak-form inefficient (persistence of historical
prices)
Olowe (1999) found Nigerian Stock Exchange to be weak-form efficient
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Current State of Knowledge
Advanced markets are largely efficient but anomalies still exist
Seasonalities Day of the week effects (returns are higher on
average on the last trading day (Friday) and lower on the first (Monday)
High returns to stocks in January A small group of portfolio managers (US
mutual funds) seem to consistently earn above normal profits
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The Controversy Continues
Can markets be efficient – inefficiency is what propels markets towards efficiency as investors seek out profit opportunities
Behavioral approach suggests that markets don’t just trade on available news and rational response; they reflect irrational impulses (Greenspan’s “irrational exuberance”)
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Implications for Investors
If EMH holds:Published reports of financial Analysts may
not be valuableMarket tips are not valuableTechnical analysis is worthless with weak-
form efficiencyFundamental analysis is worthless with
semi-strong efficiency There should be low returns to active
portfolio management
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What should Investors Do?
For the vast majority, public information cannot be used to beat market Select diversified portfolio and avoid costs of analysis
and transaction Many investors place their funds with managers who
merely replicate an index thus lowering costs
Investors groups (institutional investors, shareholders associations, etc) need to press for greater volume of timely information to move markets closer to the semi-strong efficient markets level, thus boosting market confidence
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Market Efficiency
• The value of investment advice– Forbes’ Magazine’s monkey portfolio
Not all financial theory is good for the financial profession!
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Implications for Corporate Finance
Key Corporate Finance Decisions: Should firms try to time their security issues or is
market timing a hopeless venture? How do markets react to different security issues?
How can firms use this information to decide which securities they should issue to raise funds?
What happens if firms are inefficient? Can firms exploit these inefficiencies in their financing decisions?
Can financial managers “fool” the market by “cooking their books”?
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The Corporate Finance Evidence
Persistence of January effect means firms can take advantage
Mean reverting interest rates means that when interest rates are high based on historical levels they are likely to come down
Stock prices at historical lows are likely to go up BUT
Advantages are only reasonable at the margins. Gains are too low and noise is too high
Financial managers should not ignore important considerations of funding to take advantage of market inefficiencies
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Can Financial Managers Cook the Books?
Change in accounting methods to boost profit (e.g. depreciation methods, pooling versus purchase) tend to elicit negative to neutral market reaction
Stock splits/Bonus shares – Neutral Profit announcements: Delays create negative
market reaction Lesson: Financial managers are unlikely to
“fool” market; but regulatory firmness is essential (ENRON cooked its books for over 4 years before the market caught up with it)
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Implications of Regulators
Regulators accept efficient markets as normative model; IOSCO Objectives and Principles of Securities Regulation stress:The protection of investorsEnsuring that markets are fair, efficient and
transparentThe reduction of systemic risk
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Quote
“In an efficient market, the dissemination of relevant information is timely and widespread and is reflected in the price formation process. Regulation should promote efficiency” (IOSCO Principles and Objectives of Securities Regulation)
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Regulatory Prescriptions
There should be full, timely and accurate disclosure of financial results and other information that is material to investors’ decisions
Holders of securities in a company should be treated in a fair and equitable manner
Accounting and auditing standards should be of a high and internationally acceptable quality
The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers.
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Market Efficiency and Stages of Market Development
Recent research relates market efficiency to stage of market developmentPre-emergingEmergingAdvanced markets
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Stages of market Development (Contd)
Pre-emerging (Most sub-Saharan Africa excl. SA) Immature market, market efficiency is low Low market professionalism Market inefficiencies not fully exploited Low returns to active management
Emerging Markets starts to professionalize More analysis Returns to active management are high Market becomes more efficient
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Market Efficiency and Stages of Market Development (Contd)
Advanced markets (3 stages) Too much active management
No more unexploited market opportunities Returns to active management fall Market efficiency peaks
Indexation penetration increasing (UK, Continental Europe, US)
Increasing reliance on indexation Some market opportunities go unexploited Returns to active management increase again but levels off
Equilibrium Market is not fully efficient Some returns to active management still exist but at a lower level
than earlier phase
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What should Africa do to improve market efficiency?
Need for more professionalism Better regulatory enforcement
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Building Professionalism and market Capacity
Extensive training needed Larger and strong investment houses with capability to
organize information Participation by investment houses from advanced
markets will be a plus for market efficiency (partnerships between SA and other sub-Saharan Africa investment houses may be a good start)
More technical know-how is needed in our stock markets ASEA should build technical know-how of members Formalized collaboration between ASEA, ACMF and
development agencies (e.g. UNECA, ADB, etc) is needed to lift capacity and build professionalism)
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The Importance of Regulatory Enforcement
Without strong regulatory enforcement, market efficiency will be elusive
Major regulatory agencies such as US SEC have failed to detect major inaccuracies in company accounts and nondisclosure (ENRON, Worldcom)
African regulators are poorly resourced Poor market surveillance Limited analytical and investigative capacities