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Market Efficiency. The Efficient Market Hypothesis (EMH) Types of empirical tests, and the empirical evidence Event studies Performance of portfolio managers Anomalies Behavourial finance. A. Efficient Market Hypothesis (EMH). Efficient Markets
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Market Efficiency • The Efficient Market Hypothesis (EMH) • Types of empirical tests, and the empirical evidence • Event studies • Performance of portfolio managers • Anomalies • Behavourial finance
A. Efficient Market Hypothesis (EMH) • Efficient Markets • Prices quickly, fully and accurately reflect all available and relevant information • Will focus primarily on the stock market • Why look at market efficiency? • Implications for business • Price as a signal for resource allocation • Implications for investment • Active versus passive strategies
Conditions for an Efficient Market • Large number of rational, profit-maximizing investors • Actively participate in the market • Competitive market: price takers • Information is costless, and widely available to all investors (Regulation FD - Fair Disclosure) • Investors react quickly and fully to new information • Profit opportunity motivates research and competition among investors
Consequences of Market Efficiency • Quick stock price adjustment to the arrival of new information • By definition of new information, it is unpredictable • Hence, future price changes are unpredictable
Regulation FD • Market efficiency is not just an academic concept SEC: “Congress sought to promote disclosure of ‘honest, complete and correct information’ to facilitate the operation of fair and efficient markets”
Regulation FD • Before: companies filed periodic reports. Issuers did not necessarily have to publicly disclose all material events as soon as they occur • Consequences: selective disclosure. Issuers had control over timing and audience, as well as the forum of disclosure
Regulation FD (cont’d) • Potential problems associated with selective disclosure: • Analysts: less independent research, rely more on access to privileged corporate information • Analysts feel pressure to report favourably about companies to avoid being “cut off” • Trading on short-term information, rather than fundamental analysis
Three forms of the EMH • Efficient Market Hypothesis (EMH) • A very general statement - difficult to test • Three forms of the EMH Difference: definition of the information set • Weak form - market level data • Semi-strong form - all public information • Strong form - all information, both public and private (insider information)
Weak Form • Security prices reflect all past price and volume data • Implication: investors cannot consistently earn abnormal returns (in excess of risk-adjusted level) using market level data • Security prices adjust or incorporate market level data quickly and fully
Semistrong Form • Prices reflect all publicly available information • Implication: investors cannot consistently earn abnormal returns using publicly available information • Investors cannot act on new public information after its announcement and expect to earn an abnormal return • Encompasses the weak form as a subset
B. Empirical Tests of Market Efficiency • Weak form • Look for possible patterns in stock returns • Trading rules vs. buy-and-hold • Semistrong form • Event studies (FINE5200/6100) • Assessing performance of professional managers
Data Snooping • “Give enough computer time, we are sure that we can find a mechanical trading rule which “works” on a set of random numbers – provided of course that we are able to test the rule on the same table of numbers which we used to discover the rule.” (Jensen & Bennington 1970).
Semistrong form: Evidence Two types of tests: 1. Event studies • Empirical analysis of stock price behaviour surrounding a particular event (e.g., stock splits, mergers, earnings announcements … ) • Focus: speed of stock price adjustment to new information (announcement of event) 2. Performance of portfolio managers • Can they consistently beat the market using public information?
