Ch09 Edited

8/4/2019 Ch09 Edited

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The Capital Markets andMarket Efficiency

Group 1


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The notion that science, left to itself, is bound toevolve more and more of the truth about the world

is another illusion, for science can never existoutside a society, and that society, whether

deliberately or unconsciously, directs its course.

- Northrop Frye


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OutlineIntroduction

Role of the capital markets

Efficient market hypothesis

Technical Analysis

Fundamental Analysis


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IntroductionCapital market theory springs from the

notion that:

People like return

People do not like risk

Dispersion around expected return is a

reasonable measure of risk


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Role of the Capital MarketsDefinition

Economic function

Continuous pricing function

Fair price function


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DefinitionCapital markets trade securities with lives

of more than one year

Examples of capital markets

New York Stock Exchange (NYSE)

American Stock Exchange (AMEX) Chicago Board of Trade

Chicago Board Options Exchange (CBOE)


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Economic FunctionThe economic function of capital markets

facilitates the transfer of money from savers

to borrowers E.g., mortgages, Treasury bonds, corporate

stocks and bonds


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Continuous Pricing FunctionThecontinuous pricing function of capital

markets means prices are available moment

by moment Continuous prices are an advantage to investors

Investors are less confident in their ability toget a quick quotation for securities that do not

trade often


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Fair Price FunctionThefair price function of capital markets

means that an investor can trust the

financial system The function removes the fear of buying orselling at an unreasonable price

The more participants and the more formal themarketplace, the greater the likelihood that thebuyer is getting a fair price


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Efficient Market HypothesisDefinition

Types of efficiency

Weak form

Semi-strong form

Strong form

Semi-efficient market hypothesis

Security prices and random walks


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Types of EfficiencyOperational efficiency measures how well

things function in terms of speed of

execution and accuracy It is a function of the number of order that are

lost or filled incorrectly

It is a function of the elapsed time between the

receipt of an order and its execution


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Types of Efficiency (contd)Informational efficiency is a measure of

how quickly and accurately the market

reacts to new information It relates directly to the EMH

The market is informationally very efficient

Security prices adjust rapidly and accurately to newinformation

The market is still not completely efficient


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Weak FormDefinition

Charting

Runs test

Technical Analysis



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DefinitionThe weak form of the EMH states that it is

impossible to predict future stock prices by

analyzing prices from the past The current price is a fair one that considers

any information contained in the past price data

Charting techniques or of no use in predicting

stock prices


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Definition (contd)Example

Which stock is a better buy?

Stock A

Stock B

Current Stock Price


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Definition (contd)Example (contd)

Solution: According to the weak form of the EMH,neither stock is a better buy, since the current price

already reflects all past information.


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ChartingPeople who study charts aretechnical

analysts orchartists

Chartists look for patterns in a sequence ofstock prices

Many chartists have a behavioral element


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Runs TestAruns test is a nonparametric statistical

technique to test the likelihood that a series

of price movements occurred by chance Arun is an uninterrupted sequence of the sameobservation

A runs test calculates the number of ways an

observed number of runs could occur given therelative number of different observations andthe probability of this number


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Conducting A Runs Test

1 2

1 2

1 2 1 2 1 2

21 2 1 2

1 2

where number of runs

21

2 (2 )

( 1)

, number of observations in each category

standard normal variable

R xZ

R

n nx

n n

n n n n n n

n n n n

n n

Z


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Semi-Strong FormThe semi-strong form of the EMH states

that security prices fully reflect all publicly

available information E.g., past stock prices, economic reports,

brokerage firm recommendations, investment

advisory letters, etc.


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Semi-Strong Form (contd)Academic research supports the semi-strong

form of the EMH by investigating various

corporate announcements, such as: Stock splits

Cash dividends

Stock dividends

This means investor are seldom going tobeat the market by analyzing public news


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Strong FormThe strong form of the EMH states that

security prices fully reflect all public and

private informationThis means even corporate insiders cannot

make abnormal profits by using inside

information Inside information is information not available

to the general public


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Semi-Efficient

Market HypothesisThesemi-efficient market hypothesis

(SEMH) states that the market prices some

stocks more efficiently than others Less well-known companies are less efficiently

priced

The market may be tiered

A security pecking order may exist


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Security Prices and

Random WalksThe unexpected portion of news follows a

random walk

News arrives randomly and security pricesadjust to the arrival of the news

We cannot forecast specifics of the news very

accurately


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Technical analysis is a financial term used to

denote a security analysis discipline for

forecasting the direction of prices through the

study of past market data, primarily price and

volume. Behavioural economic and quantitive

analysis incorporate technical analysis, whichbeing an aspect of active management stands in

contradiction to much of modern portfolio theory.

The efficacy of both technical and fundamental

analysis is disputed by efficient-market

hypothesis which states that stock market prices

are essentially unpredictable.


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Based upon the belief that stock market values

reflect economic values. And that there is

publicly available information that will allow

them to form a better estimate of value than is

contained in market prices. If there is information (examples?) that will

allow an analyst to form a better estimate of

future dividends (or cash flow) than themarket's estimate, as reflected in current price,

then there may be money to be made.

In liquid, standard markets, its not too likely.


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