Chapter 9
The Capital Markets and
Market Efficiency
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The notion that science, left to itself, is bound to
evolve more and more of the truth about the world
is another illusion, for science can never exist
outside a society, and that society, whether
deliberately or unconsciously, directs its course.
- Northrop Frye
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Outline
 Introduction
 Role
of the capital markets
 Efficient market hypothesis
 Anomalies
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Introduction
 Capital
market theory springs from the
notion that:
• People like return
• People do not like risk
• Dispersion around expected return is a
reasonable measure of risk
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Role of the Capital Markets
 Definition
 Economic
function
 Continuous pricing function
 Fair price function
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Definition
 Capital
markets trade securities with lives
of more than one year
 Examples
•
•
•
•
of capital markets
New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
Chicago Board of Trade
Chicago Board Options Exchange (CBOE)
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Economic Function
 The
economic function of capital markets
facilitates the transfer of money from savers
to borrowers
• E.g., mortgages, Treasury bonds, corporate
stocks and bonds
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Continuous Pricing Function
 The
continuous pricing function of capital
markets means prices are available moment
by moment
• Continuous prices are an advantage to investors
• Investors are less confident in their ability to
get a quick quotation for securities that do not
trade often
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Fair Price Function
 The
fair price function of capital markets
means that an investor can trust the
financial system
• The function removes the fear of buying or
selling at an unreasonable price
• The more participants and the more formal the
marketplace, the greater the likelihood that the
buyer is getting a fair price
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Efficient Market Hypothesis
 Definition
 Types
of efficiency
 Weak form
 Semi-strong form
 Strong form
 Semi-efficient market hypothesis
 Security prices and random walks
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Definition
 The
efficient market hypothesis (EMH) is
the theory supporting the notion that market
prices are in fact fair
• The EMH is perhaps the most important
paradigm in finance
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Types of Efficiency
 Operational
efficiency measures how well
things function in terms of speed of
execution and accuracy
• It is a function of the number of order that are
lost or filled incorrectly
• It is a function of the elapsed time between the
receipt of an order and its execution
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Types of Efficiency (cont’d)
 Informational
efficiency is a measure of
how quickly and accurately the market
reacts to new information
• It relates directly to the EMH
• The market is informationally very efficient
– Security prices adjust rapidly and accurately to new
information
– The market is still not completely efficient
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Weak Form
 Definition
 Charting
 Runs
test
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Definition
 The
weak form of the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past
• The current price is a fair one that considers
any information contained in the past price data
• Charting techniques or of no use in predicting
stock prices
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Definition (cont’d)
Example
Which stock is a better buy?
Stock A
Current Stock Price
Stock B
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Definition (cont’d)
Example (cont’d)
Solution: According to the weak form of the EMH, neither
stock is a better buy, since the current price already
reflects all past information.
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Charting
 People
who study charts are technical
analysts or chartists
• Chartists look for patterns in a sequence of
stock prices
• Many chartists have a behavioral element
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Runs Test
 A runs
test is a nonparametric statistical
technique to test the likelihood that a series
of price movements occurred by chance
• A run is an uninterrupted sequence of the same
observation
• A runs test calculates the number of ways an
observed number of runs could occur given the
relative number of different observations and
the probability of this number
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Conducting A Runs Test
Z
Rx

where R  number of runs
2n1n2
x
1
n1  n2

2n1n2 (2n1n2  n1  n2 )
 n1  n2 
2
(n1  n2  1)
n1 , n2  number of observations in each category
Z  standard normal variable
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Semi-Strong Form
 The
semi-strong form of the EMH states
that security prices fully reflect all publicly
available information
• E.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.
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Semi-Strong Form (cont’d)
 Academic
research supports the semi-strong
form of the EMH by investigating various
corporate announcements, such as:
• Stock splits
• Cash dividends
• Stock dividends
 This
means investor are seldom going to
beat the market by analyzing public news
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Strong Form
 The
strong form of the EMH states that
security prices fully reflect all public and
private information
 This means even corporate insiders cannot
make abnormal profits by using inside
information
• Inside information is information not available
to the general public
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Semi-Efficient
Market Hypothesis
 The
semi-efficient market hypothesis
(SEMH) states that the market prices some
stocks more efficiently than others
• Less well-known companies are less efficiently
priced
• The market may be tiered
• A security pecking order may exist
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Security Prices and
Random Walks
 The
unexpected portion of news follows a
random walk
• News arrives randomly and security prices
adjust to the arrival of the news
– We cannot forecast specifics of the news very
accurately
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Anomalies
 Definition
 Low
PE effect
 Low-priced stocks
 Small firm effect
 Neglected firm effect
 Market overreaction
 January effect
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Anomalies (cont’d)
 Day-of-the-week
effect
 Turn-of-the calendar effect
 Persistence of technical analysis
 Chaos theory
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Definition
 A financial
anomaly refers to unexplained
results that deviate from those expected
under finance theory
• Especially those related to the efficient market
hypothesis
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Low PE Effect
 Stocks
with low PE ratios provide higher
returns than stocks with higher PEs
 Supported
by several academic studies
 Conflicts
directly with the CAPM, since
study returns were risk-adjusted (Basu)
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Low-Priced Stocks
 Stocks
with a “low” stock price earn higher
returns than stocks with a “high” stock price
 There
is an optimum trading range
 Every
stock with a “high” stock price
should split
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Small Firm Effect
 Investing
in firms with low market
capitalization will provide superior riskadjusted returns
 Supported
by academic studies
 Implies
that portfolio managers should give
small firms particular attention
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Neglected Firm Effect
 Security
analysts do not pay as much
attention to firms that are unlikely portfolio
candidates
 Implies
that neglected firms may offer
superior risk-adjusted returns
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Market Overreaction
 The
tendency for the market to overreact to
extreme news
• Investors may be able to predict systematic
price reversals
 Results
because people often rely too
heavily on recent data at the expense of the
more extensive set of prior data
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January Effect
 Stock
returns are inexplicably high in
January
 Small
firms do better than large firms early
in the year
 Especially
pronounced for the first five
trading days in January
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January Effect (cont’d)
 Possible
explanations:
• Tax-loss trading late in December (Branch)
• The risk of small stocks is higher early in the
year (Rogalski and Tinic)
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Types of Firms in January
January
return
January return minus
average monthly return
in rest of year
January return
after adjusting for
systematic risk
Highly Researched
2.48%
1.63%
-1.44%
Moderately
Researched
4.95%
4.19%
1.69%
Neglected
7.62%
6.87%
5.03%
11.32%
10.72%
7.71%
S&P 500
Companies
Non-S&P 500
Companies
Neglected
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Day-of-the-Week Effect
 Mondays
are historically bad days for the
stock market
 Wednesday
and Fridays are consistently
good
 Tuesdays
and Thursdays are a mixed bag
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Day-of-the-Week
Effect (cont’d)
 Should
not occur in an efficient market
• Once a profitable trading opportunity is
identified, it should disappear
 The
day-of-the-week effect continues to
persist
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Turn-of-the-Calendar Effect
 The
bulk of returns comes from the last
trading day of the month and the first few
days of the following month
 For
the rest of the month, the ups and
downs approximately cancel out
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Persistence of
Technical Analysis
 Technical
analysis refers to any technique
in which past security prices or other
publicly available information are employed
to predict future prices
 Studies show the markets are efficient in the
weak form
 Literature based on technical techniques
continues to appear but should be useless
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Chaos Theory
 Chaos
theory refers to instances in which
apparently random behavior is systematic or
even deterministic
 “Econophysics” refers to the application of
physics principles in the analysis of stock
market behavior
• E.g., an investment strategy based on studies of
turbulence in wind tunnels
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