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Chapter 8

Efficient Market Hypothesis

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Efficient Market Hypothesis (EMH)Do security prices reflect information ?Why look at market efficiency

Implications for business and corporate financeImplications for investment

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Random Walk - stock prices are randomActually submartingale

Expected price is positive over timePositive trend and random about the trend

Random Walk and the EMH

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Security Prices

Time

Random Walk with Positive Trend

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Why are price changes random?Prices react to informationFlow of information is randomTherefore, price changes are random

Random Price Changes

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EMH and CompetitionStock prices fully and accurately reflect publicly

available informationOnce information becomes available, market

participants analyze itCompetition assures prices reflect information

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Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts

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Figure 8-2 Returns Following Earnings Announcements

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Forms of the EMHWeakSemi-strongStrong

Are Markets Efficient?The Magnitude Issue

- Consider an investment manager overseeing a $2 billion portfolio.

- If she can improve performance by only 1/10th of 1 percent per year, that effort will be worth .001 x $2 billion = $2 million annually.

- This manager clearly would be worth her salary! Yet can we, as observers, statistically measure her contribution?

- Probably not: a 1/10th of 1 percent contribution would be swamped by the yearly volatility of the market

Are Markets Efficient?The Selection Bias Issue

- Only investors who find that an investment scheme cannot generate abnormal returns will be willing to report their findings to the whole world.

The Lucky Event Issue

- If many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets.

- The winners, though, turn up in The Wall Street Journal as the latest stock market gurus; then they can make a fortune publishing market newsletters.

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Types of Stock AnalysisTechnical Analysis - using prices and volume information to

predict future pricesWeak form efficiency & technical analysis

Fundamental Analysis - using economic and accounting information to predict stock pricesSemi strong form efficiency & fundamental analysis

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Active ManagementSecurity analysisTiming

Passive ManagementBuy and HoldIndex Funds

Implications of Efficiency for Active or Passive Management

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

Appropriate risk levelTax considerationsOther considerations

Market Efficiency and Portfolio Management

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Event studiesAssessing performance of professional

managersTesting some trading rule

Empirical Tests of Market Efficiency

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1. Examine prices and returns over time

How Tests Are Structured

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0 +t-t

Announcement Date

Returns Surrounding the Event

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2. Returns are adjusted to determine if they are abnormalMarket Model approach

a. Rt = at + btRmt + et

(Expected Return)

b. Excess Return = (Actual - Expected)

et = Actual - (at + btRmt)

How Tests Are Structured (cont.)

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2. Returns are adjusted to determine if they are abnormalMarket Model approach

c. Cumulate the excess returns over time:

0 +t-t

How Tests Are Structured (cont.)

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Magnitude IssueSelection Bias IssueLucky Event Issue

Issues in Examining the Results

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Exercise 2431. The semi-strong form EMH states that ________ must be reflected in the stock price.

A) all market trading data B) all publicly available information C) all information including inside information D) none of the above

2. _________ considerations make portfolio management useful even in a perfectly efficient market. A) Diversification B) Investor tax C) Investor risk profile D) all of the above

3. The term random walk is used in investments to refer to ______________. A) stock price changes that are random but predictable B) stock prices that respond slowly to both old and new information C) stock price changes that are random and unpredictable D) stock prices changes that follow the pattern of past price changes

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Exercise421. A market anomaly refers to ____.

A) an exogenous shock to the market that is sharp but not persistent B) a price or volume event that is inconsistent with historical price or volume trends C) a trading or pricing structure that interferes with efficient buying and selling of securities D) price behavior that differs from the behavior predicted by the efficient market hypothesis

2. The semi-strong form of the efficient market hypothesis contradicts __________. A) technical analysis, but supports fundamental analysis as valid B) fundamental analysis, but supports technical analysis as valid C) both fundamental analysis and technical analysis D) technical analysis, but is silent on the possibility of successful fundamental analysis