The Efficient Market Hypothesis

1. Department of Banking and Finance SPRING 2007-08 The Efficient Market Hypothesis by Asst. Prof. Sami Fethi

2. 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.

3. Efficient 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).

4. Efficient 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.

5. Random 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 time • Positive trend and random about the trend

6. Random Walk with Positive Trend Security Prices Time

7. Random Price Changes • 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.

8. Competition 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

9. Forms of the EMH Strong Form Efficiency • Weak • Semi-strong • Strong Semi-Strong Form Efficiency Weak Form Efficiency

10. Weak-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.

11. Semi-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, rightissues, technological breakthroughs, and so on. It indicates that it is not possible to outperform the market average return except by chance.

12. Strong-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.

13. Forms 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.

14. The 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.

15. Supportive 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).

16. Types 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

17. Implications of Efficiency for Active or Passive Management • Active Management • Security analysis • Timing • Passive Management • Buy and Hold • Index Funds

18. Active 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.

19. Active 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.

20. Market Efficiency and Portfolio Management Even if the market is efficient, a role exists for portfolio management • Appropriate risk level • Tax considerations • Other considerations

21. Empirical Tests of Market Efficiency • Event studies • Assessing performance of professional managers • Testing some trading rule

22. How Tests Are Structured 1. Examine prices and returns over time

23. Returns Surrounding the Event -t 0 +t Announcement Date

24. How Tests Are Structured (cont.) 2. Returns are adjusted to determine if they are abnormal Market Model approach a. Rt = at + btRmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = Actual - (at + btRmt)

25. How Tests Are Structured (cont.) 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: -t 0 +t

26. Issues in Examining the Results • To discuss empirical tests of hypothesis, the following factors should be taken into account: • Magnitude Issue • Selection Bias Issue • Lucky Event Issue

27. Tests 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

28. Tests of Semi-strong Form: Anomalies • Small Firm Effect (January Effect) • Neglected Firm • Market to Book Ratios • Post-Earnings Announcement Drift • Higher Level Correlation in Security Prices

29. Implications of Test Results • Risk Premiums or market inefficiencies • Anomalies or data mining • Behavioral Interpretation • Inefficiencies exist • Caused by human behavior

30. Behavioral Possibilities • Forecasting Errors • Overconfidence • Regret avoidance • Framing and mental accounting errors

31. Mutual Fund and Professional Manager Performance • Some evidence of persistent positive and negative performance • Potential measurement error for benchmark returns • Style changes • May be risk premiums • Superstar phenomenon

33. Market 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.

34. Weak-form Efficiency Exploiting predictable patterns in price movements

35. Weak-form Efficiency • 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.

36. Weak-form Efficiency 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 t Reflects New information after t-1, and is uncorrelated with all functions of P–i, i> 0.

37. 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.

38. 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 +t

39. General formula

40. Theory 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 |Wt]

41. 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

42. Rational Expectations (cont…) Implications: • If there is a change in the way a variable moves, then the way expectations are formed also changes • Forecast errors on average = 0 and are not predictable

43. Efficient Markets Hypothesis Pt+1 – Pt + C RET = Pt Pet+1 – Pt + C RETe = Pt Rational Expectations implies: Pet+1 = Poft+1RETe = RETof (1) Market equilibrium RETe = RET* (2)

44. Efficient Markets Hypothesis Put (1) and (2) together: Efficient Markets Hypothesis RETof = RET*

45. Why the Efficient Markets Hypothesis makes sense • If RETof > RET* Pt, RETof • If RETof < RET* Pt, RETof until RETof = RET* Note: • All unexploited profit opportunities eliminated • Efficient Market holds even if are uninformed, irrational participants in market

46. Evidence on Efficient Markets Hypothesis Favorable Evidence • Investment analysts and mutual funds don’t beat the market • Stock prices reflect publicly available information: anticipated announcements don’t affect stock price • Stock prices and exchange rates close to random walk • If predictions of P big, Rof > R* predictions of P small • Technical analysis does not outperform market

47. Evidence on Efficient Markets Hypothesis Unfavorable Evidence • Small-firm effect: small firms have abnormally high returns • January effect: high returns in January • Market overreaction • Excessive volatility • Mean reversion • New information is not always immediately incorporated into stock prices

48. The End Thanks