The Efficient Market
Hypothesis
CHAPTER 11
Efficient Market Hypothesis (EMH)
• Do security prices reflect information ?
• Why look at market efficiency?
– Implications for business and corporate finance
– Implications for investment
Figure 11.1 Cumulative Abnormal Returns Before
Takeover Attempts: Target Companies
Figure 11.2 Stock Price Reaction to CNBC Reports
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
The market price is more informative (accurate) than
individual value estimates
V = the true fundamental value,
P = the market price,
vi = value estimate of trader i; vi = V + ei, where E(ei) = 0,
Di = trader i’s desired position in the security;
Di = a(vi – P), where a is a constant.
From ∑ Di = ∑ a(vi – P) = 0 (i.e., zero net supply), we have
∑ a(vi – P) = 0 → a∑(vi – P) = 0 → ∑(vi – P) = 0 → ∑vi – ∑P = 0
→ ∑vi = ∑P = N * P → P = (1/N) ∑vi
P = (1/N) ∑vi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.
Versions of the EMH
• Weak
• Semi-strong
• Strong
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
Active or Passive Management
• Active Management
– Security analysis
– Timing
• Passive Management
– Buy and Hold
– Index Funds
Market Efficiency & Portfolio Management
Even if the market is efficient a role exists for
portfolio management:
• Appropriate risk level
• Tax considerations
• Other considerations
Event Studies
• Empirical financial research that enables an
observer to assess the impact of a particular
event on a firm’s stock price
• Abnormal return due to the event is estimated as
the difference between the stock’s actual return
and a proxy for the stock’s return in the absence
of the event
How Tests Are Structured
•
Returns are adjusted to determine if they are
abnormal
Market Model approach
a. rt = at + brmt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
et = rt - (a + brMt)
Are Markets Efficient
• Magnitude Issue
• Selection Bias Issue
• Lucky Event Issue
Weak-Form Tests
• Returns over the Short Horizon
– Momentum
• Returns over Long Horizons
Predictors of Broad Market Returns
• Fama and French
– Aggregate returns are higher with higher
dividend ratios
• Campbell and Shiller
– Earnings yield can predict market returns
• Keim and Stambaugh
– Bond spreads can predict market returns
Semistrong Tests: Anomalies
•
•
•
•
•
P/E Effect
Small Firm Effect (January Effect)
Neglected Firm Effect and Liquidity Effects
Book-to-Market Ratios
Post-Earnings Announcement Price Drift
Figure 11.3 Average Annual Return for 10 SizeBased Portfolios, 1926 – 2006
Figure 11.4 Average Return as a Function of BookTo-Market Ratio,
1926–2006
Figure 11.5 Cumulative Abnormal Returns in
Response to Earnings Announcements
Strong-Form Tests: Inside Information
• The ability of insiders to trade profitability in their
own stock has been documented in studies by
Jaffe, Seyhun, Givoly, and Palmon
• SEC requires all insiders to register their trading
activity
Interpreting the Evidence
• Risk Premiums or market inefficiencies—
disagreement here
– Fama and French argue that these effects can
be explained as manifestations of risk stocks
with higher betas
– Lakonishok, Shleifer, and Vishney argue that
these effects are evidence of inefficient
markets
Interpreting the Evidence Continued
• Anomalies or Data Mining
• The noisy market hypothesis
• Fundamental indexing
Stock Market Analysts
• Do Analysts Add Value
– Mixed evidence
– Ambiguity in results
Mutual Fund Performance
• Some evidence of persistent positive and
negative performance
• Potential measurement error for benchmark
returns
– Style changes
– May be risk premiums
• Hot hands phenomenon
Figure 11.7 Estimates of Individual Mutual
Fund Alphas, 1972 - 1991
Table 11.1 Performance of Mutual Funds
Based on Three-Index Model
Figure 11.8 Persistence of Mutual Fund
Performance
Table 11.2 Two-Way Table of Managers
Classified by Risk-Adjusted Returns over
Successive Intervals