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Understanding Market Efficiency: Insights on EMH and its Implications for Finance and Investments

In this chapter, we explore the Efficient Market Hypothesis (EMH), which posits that security prices reflect all available information. We discuss why market efficiency is crucial for business, corporate finance, and investment strategies. The concepts of random walk theory and price changes are examined, highlighting how stock prices react to new information in a competitive landscape. We also analyze different forms of efficiency (weak, semi-strong, strong) and their implications for active versus passive management. Empirical tests of market efficiency, anomalies, and the performance of professional managers are also covered.

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Understanding Market Efficiency: Insights on EMH and its Implications for Finance and Investments

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Presentation Transcript

  1. Chapter 12 MarketEfficiency

  2. Efficient Market Hypothesis (EMH) • Do security prices reflect information ? • Why look at market efficiency • Implications for business and corporate finance • Implications for investment

  3. Random Walk and the EMH • Random Walk - stock prices are random • Actually submartingale • Expected price is positive over time • Positive trend and random about the trend

  4. Security Prices Time Random Walk with Positive Trend

  5. Random Price Changes Why are price changes random? • Prices react to information • Flow of information is random • Therefore, price changes are random

  6. EMH and Competition • Stock prices fully and accurately reflect publicly available information • Once information becomes available, market participants analyze it • Competition assures prices reflect information

  7. Forms of the EMH • Weak • Semi-strong • Strong

  8. 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

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

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

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

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

  13. -t 0 +t Announcement Date Returns Over Time

  14. How Tests Are Structured (cont’d) 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)

  15. How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: -t 0 +t

  16. Issues in Examining the Results • Magnitude Issue • Selection Bias Issue • Lucky Event Issue • Possible Model Misspecification

  17. What Does the Evidence Show? • Technical Analysis • Short horizon • Long horizon • Fundamental Analysis • Anomalies Exist

  18. Anomalies • Small Firm Effect (January Effect) • Neglected Firm • Market to Book Ratios • Reversals • Post-Earnings Announcement Drift • Market Crash of 1987

  19. 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

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