ses 2-efficient market hypothesis

7/31/2019 Ses 2-Efficient Market Hypothesis

1/17

Session -2

The Efficient Market Hypothesis

0 10-07-12M.BASHYAKAR


2/17

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.


3/17

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.


4/17

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.


5/17

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


6/17

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.


7/17

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.


8/17

Relationship among 3 Different Information

Sets

7

All informationrelevant to a stock

Information set

of publicly availableinformation

Informationset of

past prices


9/17

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.


10/17

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.


11/17

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


12/17

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.


13/17

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.


14/17

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.


15/17

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


16/17

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.


17/17

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.

ses 2-efficient market hypothesis

Documents