GD31403 Week 5 Efficient Capital Markets. 6-2 Why Should the Markets Be Efficient? Premises of An...

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Efficient Capital MarketsEfficient Capital Markets

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Why Should the Markets Be Efficient?Why Should the Markets Be Efficient?

• Premises of An Efficient Market

– A large number of competing profit-maximizing participants analyze and value securities, each independently of the others

– New information regarding securities comes to the market in a random fashion

– Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information

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Why Should the Markets Be Efficient?Why Should the Markets Be Efficient?

• The Results

– Security price changes should be independent and random

– The security prices that prevail at any time should be an unbiased reflection of all currently available information

– In an efficient market, the expected returns implicit in the current price of a stock should be consistent with the perceived risk of the stock

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Efficient Market Hypotheses (EMH)Efficient Market Hypotheses (EMH)

• Random Walk Hypothesis – Changes in security prices occur randomly

• Fair Game Model – Current market price reflect all available

information about a security and the expected return based upon this price is consistent with its risk

• Efficient Market Hypothesis (EMH) – Divided into three sub-hypotheses depending

on the information set involved (Fama, 1970).

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EMH in Fama (1970)EMH in Fama (1970)

(1) Weak-Form EMH

– Current prices reflect all security-market historical information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information

– This implies that past rates of return and other market data should have no relationship with future rates of return

– In short, prices reflect all historical information

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(2) Semi-strong Form EMH

– Current security prices reflect all public information, including market and non-market information

– This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

– In short, prices reflect all public information


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(3) Strong-Form EMH

– Stock prices fully reflect all information from public and private sources

– This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return

– This assumes perfect markets in which all information is cost-free and available to everyone at the same time

– In short, prices reflect all public & private information


EMH in Fama (1970)

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Weak: How well do past returns predict future returns?Semi-strong: How quickly do stock prices reflect public information announcement?Strong: Do any investors have private information that is not fully reflected in market price?

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Tests of Weak-Form EMHTests of Weak-Form EMH

(1) Statistical Tests of Independence

– Determine whether the asset prices follow a random walk, or more strictly a martingale.

– Numerous statistical tests have been employed, e.g.

• Autocorrelation tests • Runs tests• Long memory tests• Non-linearity tests

For a review of the statistical tests, see the survey paper by Lim and Brooks (2011, JES)

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Tests of Weak-Form EMHTests of Weak-Form EMH

(2) Profitability of Technical Trading Rules

– Almost infinite number of trading rules

– The most common one is filter rules

– Use only publicly available data

– Include transaction costs (the emphasis is on profitability and not predictability)

– Adjust the results for risk

For a review, see the survey paper by Park and Irwin (2007, JES)

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Tests of Semi-strong Form EMHTests of Semi-strong Form EMH

Event Studies

– Examine how fast stock prices adjust to specific significant economic events or public announcements.

– E.g., stock splits, initial public offerings, stock listings, merger & acquisitions, earnings, spinoffs, accounting changes.

– If the market is efficient, it would not be possible for investors to derive positive abnormal returns by investing after the release of public announcement.

00 +t+t-t-tAnnouncement DateAnnouncement Date

= abnormal return

Individual Abnormal Returns Surrounding the Event in an Efficient Market

Tests of Semi-strong Form EMH

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00 +t+t-t-t

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Individual Abnormal Returns Surrounding the Event in an Inefficient Market


Announcement DateAnnouncement Date

Abnormal Return (AR)

= Actual Return – Expected Return

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rt = a + b(rindex,t) + et

AR = et

= rt – [a + b(rindex,t)]

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In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly.

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Tests of Strong-Form EMHTests of Strong-Form EMH

• Strong-form EMH contends that stock prices fully reflect both public and private information

• This implies that no group of investors with private information will consistently earn above-average profits

• Targeted groups of investors:– Corporate insiders– Stock exchange specialists– Security analysts– Professional money managers

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(1) Tests for Return Predictability (formerly Weak-form EMH)

– The coverage was expanded beyond past returns.– Include other forecasting variables like dividend

yields, earnings yields, interest rates, bond credit spreads.

– Examine seasonality in returns like Monday Effect, January Effect, Holiday Effect.

– Consider cross-sectional predictors such as book-to-market ratio, size, price-earnings ratio, leverage, liquidity.

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EMH in Fama (1991)

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EMH in Fama (1991)

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(2) Event Studies (formerly Semi-strong form EMH)

– Same coverage.– Only a change in title.

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(3) Tests for Private Information (formerly Strong-form EMH)

– Same coverage.– Only a change in title.

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Implications of Efficient Capital MarketsImplications of Efficient Capital Markets

• Overall, the results of many studies indicate the capital markets are efficient as related to numerous sets of information

• On the other hand, there are substantial instances where the market fails to rapidly adjust to public information

• What are the implications for investors in light of these mixed evidence?

– Technical Analysis– Fundamental Analysis– Portfolio Management

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• Assumptions of technical analysis directly oppose the notion of efficient markets

• Technicians believe that new information is not immediately available to everyone, but disseminated from the informed professional first to the aggressive investing public and then to the masses

• Technicians also believe that investors do not analyze information and act immediately


(1) Technical Analysis

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• Stock prices move to a new equilibrium after the release of new information in a gradual manner, causing trends in stock price movements that persist for periods of time

• Technical analysts develop systems to detect movement to a new equilibrium (breakout) and trade based on that

• If the capital market is weak-form efficient, a trading system that depends on past trading data has no value


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• Fundamental analysts believe that there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities and these values depend on the underlying economic factors

• Investors should determine the intrinsic value of an investment at a point in time and compare it to the market price


(2) Fundamental Analysis

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• If you can do a superior job of estimating intrinsic value, you can make superior market timing decisions and generate above-average returns

• Intrinsic value analysis involves:– Aggregate market analysis– Industry and company analysis


• If intrinsic value > current stock price:

- BUY

• If intrinsic value < current stock price

- SELL

• In either case if the analysis is correct, the investor should receive an abnormal return.

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Implications of Efficient Capital Markets

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• If the markets are only weak-form efficient, fundamental analysis CAN yield abnormal returns.

• If the markets are semi-strong or strong form efficient, then fundamental analysis CANNOT yield abnormal returns.


• Active Management– – –

• Passive Management– –

Assumes inefficiency, use technical and/or fundamental analysis to pick securitiesSecurity analysis

Timing strategies

Investment Newsletters

Buy and Hold portfolios

Index Funds

Consistent with semi-strong efficiency

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(3) Portfolio Management


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

– Determine and quantify your client's risk preferences

– Construct the appropriate portfolio

– Diversify completely on a global basis to eliminate all unsystematic risk

– Maintain the desired risk level by rebalancing the portfolio whenever necessary

– Minimize total transaction costs

– Create market (index) funds which duplicate the composition and performance of a selected index series


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Behavioral FinanceBehavioral Finance

• It is concerned with the analysis of various psychological traits of individuals and how these traits affect the manner in which they act as investors, analysts, and portfolio managers

• There is no unified theory of behavioral finance and the emphasis has been on identifying portfolio anomalies that can be explained by various psychological traits

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Prospect Theory• Contends that utility depends on deviations from moving

reference point rather than absolute wealth

Overconfidence (confirmation bias)• Look for information that supports their prior opinions and

decision

Noise Traders• Influenced strongly by sentiment, they tend to move

together, which increases the prices and the volatility

Escalation Bias• Put more money into a bad investment

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Fusion Investing

• The integration of two elements of investment valuation: fundamental value & investor sentiment

• During some periods, investor sentiment is rather muted and noise traders are inactive, so that fundamental valuation dominates market returns

• In other periods, when investor sentiment is strong, noise traders are very active and market returns are more heavily impacted by investor sentiments

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Adaptive Markets Hypothesis (AMH)Adaptive Markets Hypothesis (AMH)

• With the issue of rationality in human behaviour at the heart of the controversy between the opposing camps of EMH and behavioural finance, Lo (2004) argues that valuable insights can be derived from the biological perspective and calls for an evolutionary alternative to market efficiency.

• Lo (2004) proposes the new paradigm of AMH in which the EMH can co-exist alongside behavioural finance in an intellectually consistent manner.

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Implications of AMH to portfolio management

• The equity risk premium varies over time according to the recent stock market environment and the demographics of investors in that environment.

• Arbitrage opportunities do arise in the financial markets from time to time.

• Investment products undergo cycles of superior and inferior performance in response to changing business conditions, the adaptability of investors, the number of competitors in the industry and the magnitude of profit opportunities available.

• Survival is ultimately the only objective that matters for the evolution of markets and financial technologies.

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Lo, A.W. (2004) The adaptive markets hypothesis: market efficiency from an evolutionary perspective. Journal of Portfolio Management 30(5): 15–29.

Lo, A.W. (2005) Reconciling efficient markets with behavioral finance: the adaptive markets hypothesis. Journal of Investment Consulting 7(2): 21–44.

Conceptual Papers on AMH

Survey Paper on AMHLim, K.P. and Brooks, R.D. (2011) The evolution of stock

market efficiency over time: a survey of the empirical literature. Journal of Economic Surveys 25(1), 69–10.

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Empirical Papers on AMH

Neely, C.J., Weller, P.A. and Ulrich, J. (2009) The adaptive markets hypothesis: evidence from the foreign exchange market. Journal of Financial and Quantitative Analysis 44(2), 467–488.

Kim, J.H., Shamsuddin, A. and Lim, K.P. (2011) Stock return predictability and the adaptive markets hypothesis: evidence from century-long U.S. data. Journal of Empirical Finance 18(5), 868-879.

Charles, A. Darne, O. and Kim, J.H. (2012) Exchange rate return predictability and adaptive markets hypothesis: evidence from major foreign exchange rates. Journal of International Money and Finance, forthcoming.

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