Ses 2-Efficient Market Hypothesis
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Transcript of Ses 2-Efficient Market Hypothesis
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Session -2
The Efficient Market Hypothesis
0 10-07-12M.BASHYAKAR
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A Description of Efficient Capital
Markets
1
An efficient capital market is one in
which stock prices fully reflect availableinformation.
The EMH has implications for investorsand firms.
Since information is reflected insecurity prices quickly, knowinginformation when it is releaseddoes aninvestor no good.
Firms should expect to receive the fairvalue for securities that they sell. Firmscannot profit from fooling investors in
an efficient market.
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The Different Types of Efficiency
2
Weak Form
Security prices reflect all informationfound in past prices and volume.
Semi-Strong FormSecurity prices reflect all publicly
available information.
Strong FormSecurity prices reflect all information
public and private.
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Weak Form Market Efficiency
3
Security prices reflect all information found inpast prices and volume.
If the weak form of market efficiency holds, then
technical analysis is of no value.
Often weak-form efficiency is represented as
Pt= Pt-1 + Expected return + random errort
Since stock prices only respond to newinformation, which by definition arrives
randomly, stock prices are said to follow a
random walk.
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Why Technical Analysis Fails ?
4
Stock
Price
Time
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
If it were possible to make
big money simply byfinding the pattern in
the stock price movements,
everyone would do it and
the profits would becompeted away.
Sell
Sell
Buy
Buy
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Semi-Strong Form Market
Efficiency
5
Security Prices reflect all
publicly available information.
Publicly available informationincludes:
Historical price and volume informationPublished accounting statements.
Information found in annual reports.
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Strong Form Market Efficiency
6
Security Prices reflect all informationpublic and private.
Strong form efficiency incorporates
weak and semi-strong form efficiency.Strong form efficiency says that
anything pertinent to the stock and
known to at least one investor isalready incorporated into the securitysprice.
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Relationship among 3 Different Information
Sets
7
All informationrelevant to a stock
Information set
of publicly availableinformation
Informationset of
past prices
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Major Misconception
8
Much of the criticism of
the EMH has been
based on a
misunderstanding of
what the hypothesis
says and does not say.
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What the EMH Does NOT Say
9
Investors can throw darts to select stocks.This is almost, but not quite, true.
An investor must still decide how risky aportfolio he wants based on risk aversion and
the level of expected return. Prices are random or uncaused.
Prices reflect information.
The price CHANGE is driven by new
information, which by definition arrivesrandomly.
Therefore, financial managers cannot timestock and bond sales.
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The Evidence
10
The record on the EMH is extensive,and in large measure it is reassuringto advocates of the efficiency of
markets. Studies fall into three broad
categories:
1. Are changes in stock prices random?Are there profitable tradingrules?
2. Event studies: does the market quickly
and accurately respond to new
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Are Changes in Stock Prices
Random?
11
Can we really tell?
Many psychologists and statisticians believethat most people want to see patterns even
when faced with pure randomness.People claiming to see patterns in stock price
movements are probably seeing opticalillusions.
A matter of degreeEven if we can spot patterns, we need to have
returns that beat our transactions costs.
Random stock price changes support weak-form
efficiency.
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Views Contrary to Market
Efficiency
12
Stock Market Crash of 1987The market dropped between 20 percent and
25 percent on a Monday following a weekend
during which little surprising information wasreleased.
Temporal AnomaliesTurn of the year, month, week.
Speculative BubblesSometimes a crowd of investors can behave as
a single squirrel.
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Implications for Corporate Finance
13
Because information is reflected in security pricesquickly, investors should only expect to obtain anormal rate of return.
Awareness of information when it is released doesan investor little good. The price adjusts before theinvestor has time to act on it.
Firms should expect to receive the fair value forsecurities that they sell.
Fair means that the price they receive for thesecurities they issue is the present value.
Thus, valuable financing opportunities that arisefrom fooling investors are unavailable in efficientmarkets.
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Implications for Corporate Finance
14
The EMH has three implications for corporatefinance:
1. The price of a companys stock cannot be
affected by a change in accounting.2. Financial managers cannot time issues of
stocks and bonds using publicly availableinformation.
3. A firm can sell as many shares of stocks orbonds as it desires without depressingprices.
There is conflicting empirical evidence on all
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Why Doesnt Everybody Believe the
EMH?
15
There are optical illusions, mirages, andapparent patterns in charts of stockmarket returns.
The truth is less interesting.
There is some evidence against marketefficiency:
Seasonality
Small versus Large stocksValue versus growth stocks
The tests of market efficiency are weak.
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Summary and Conclusions
16
An efficient market incorporates
information in security prices. There are three forms of the EMH:
Weak-Form EMH
Security prices reflect past price data.Semi -strong-Form EMH
Security prices reflect publicly availableinformation.
Strong-Form EMHSecurity prices reflect all information.
There is abundant evidence for the firsttwo forms of the EMH.