FINC3008 Investment Management
Lecture Week 3
MARKET EFFICIENCY
Required reading: Reilly, Chapter.6
6.1 What is an Efficient Capital Market
• An efficient capital market is one in which security
prices adjust rapidly to the arrival of new information,
and therefore, the current security prices reflect all
information about the security.
• This refers to an informationally efficient market.
6.2 Market Efficiency
• 4 assumptions of an efficient capital market
1. A large number of independent competing profit-maximising
participants analyse and value securities.
2. New information regarding securities comes to the market in a
random fashion, and the timing of one announcement is generally
independent of others.
3. All those profit-maximising investors' buy and sell decisions cause
security prices to adjust rapidly to reflect the effect of new
information.
4. Security prices should reflect all information that is publicly
available at any point of time.
6.2 Market Efficiency
• 4 conditions for the market to be efficient
1.
Information must be freely available to all
2.
There are no transaction costs or taxes
3.
There are no restrictions on trading
4.
Investors interpret the information accurately
6.2 Market Efficiency
If a market is efficient:
• Security price changes should be independent and random
• The security prices that prevail at any time should be an
unbiased reflection of all currently available information
• In an efficient market, the expected returns implicit in the
current price of a share should reflect its risk
6.2 THREE FORMS EFFICIENT MARKET
HYPOTHESIS
• Weak-form
• Prices reflect all historical information,
• E.g. historical sequence of prices, rate of return, and trading volume data
• Past rates of return and other historical market data should have no
relationship with future rates of return
• Semi-strong form
• Prices reflect all public information
• Investors who base their decisions to buy or sell on any important new
information after it is public should not derive above-average risk-adjusted
profit.
• Strong form
• Prices reflect all public and private information.
• No group of investors should be able consistently to derive above-average
risk-adjusted rates of return.
6.3 Tests of Efficient Market Hypothesis: Weak Form
Weak form
Do prices reflect the value of information from the past
trends, historical trading volumes, moving averages, etc?
2 Tests for weak form efficiency:
Statistical tests of independence:
i.
Auto-correlation: Does the rate of return on day t correlate with the
rate of return on day t-1, t-2, or t-3?
ii.
Run test: Do stock price movements follow patterns?
E.g. 3 up, 3 down, 2 up, 2 down (+++---++--)
or 2 up, 4 down, 2 up 4 down(++----++----)
6.3 Tests of Efficient Market Hypothesis: SemiStrong Form
Semi-strong form
Do security prices fully reflect public information as it enters the
market?
i.e. can analysis of stock information lead to superior return?
2 Tests for semi-strong form efficiency:
1.
Future rates of return studies: It is possible to predict future
rates of return based on non-market public information, e.g.
changes in dividend yield or quarterly earning reports
2.
Event studies examine how fast share prices adjust to
significant economic events.
To test whether it is possible to invest in security after the
public announcement of a significant event (e.g., earnings,
share splits, major economic data) and experience a significant
abnormal rate of return.
6.3 Tests of Efficient Market Hypothesis: SemiStrong Form
Anormal rate of return (pre-1980)
𝐴𝑅𝑖𝑡 = 𝑅𝑖𝑡 − 𝑅𝑚𝑡
ARit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
Example:
If a share experienced a 15 per cent increase while the market
increased 10 per cent.
𝐴𝑅𝑖𝑡 = 𝑅𝑖𝑡 − 𝑅𝑚𝑡 = 15 − 10 = 5%
The share’s abnormal return would be 5 per cent
6.3 Tests of Efficient Market Hypothesis: SemiStrong Form
Abnormal rate of return (Recent)
Since some shares are more volatile than the market and some are less
volatile, the expected rate of return for a share based on the market rate
of return and the share’s relationship with the market (beta) should be
considered.
𝐴𝑅𝑖𝑡 = 𝑅𝑖𝑡 − 𝐸(𝑅𝑖𝑡 )
𝐸(𝑅𝑖𝑡 ) = The expected rate of return for share 𝑖 during period t based on the market rate
of return and the share’s normal relationship with the market (it’s beta).
Example:
If a share experienced a 15 per cent increase while the market increased
10 per cent. The share's beta is 1.20.
𝐸(𝑅𝑖𝑡 ) = 1.20 × 10 = 12%
𝐴𝑅𝑖𝑡 = 𝑅𝑖𝑡 − 𝐸(𝑅𝑖𝑡 ) = 15 − 12 = 3%
The abnormal rate of return during the period would be 3 per cent
6.3 Tests of Efficient Market Hypothesis: Strong Form
Strong form
Does private information lead to excess return?
Testing the strong form of the EMH by analysing the
performance of the following 3 major groups of investors:
1. Corporate executives and directors in their own company
2. Security analysts
3. Professional money managers
6.4 BEHAVIORAL FINANCE
• Concerned with the analysis of various
psychological traits of individuals and how
these traits affect the manner in which they act
as investors, analysts and portfolio managers
• The emphasis has been on identifying portfolio
anomalies that can be explained by various
psychological traits.
Explaining Biases
• Prospect theory
 Contends that utility depends on deviations from
moving reference point rather than absolute wealth
• Confirmation bias
 Look for information that supports their prior
opinions and decision
• Noise traders
 Influenced strongly by sentiment, they tend to move
together, which increases the prices and the volatility
Fusion Investing
• The integration of two elements of investment
valuation ---fundamental value and investor
sentiment
• During some periods, investor sentiment is rather
muted, and noise traders are inactive so that
fundamental valuation dominates market returns.
• In other periods, when investor sentiment is
strong, noise traders are very active, and market
returns are more heavily impacted by investor
sentiments.
6.5 IMPLICATIONS OF EFFICIENT CAPITAL
MARKETS
What are the implications for investors in light of
these mixed evidence?
• Technical Analysis
• Fundamental Analysis
• Portfolio Management
Efficient Markets and Technical Analysis
• Technical analysis assumes that historical price patterns can
be used to make predictions. As security prices move in
trends that persist.
• These assumptions of technical analysis directly oppose the
notion of efficient markets - security prices adjust to new
information rapidly.
• Technicians believe that new information is not immediately
available to everyone, but disseminated from the informed
professional first to the aggressive investing public and then
to the masses
• Technicians also believe that investors do not analyse
information and act immediately. Share prices move to a
new equilibrium after the release of new information in a
gradual manner, which causes trends in share price
movements.
Efficient Markets and Technical Analysis
• If the capital market is weak-form efficient, prices fully reflect
all relevant market information. Therefore, the price of an
asset at any given time is the true and fair price it should be
ALREADY. It should never be undervalued or overvalued, as it
already incorporates any information about potential future
growth or potential downturn.
• Each time the price adjusts, it adjusts immediately and
completely to that news, so tomorrow’s price would stay the
same if no new information came in.
• It implies it is impossible to consistently achieve higher-thanaverage returns by analysing past prices and trends.
Efficient Markets and Fundamental Analysis
• Fundamental analysts believe that, at any time, there is a
basic intrinsic value for the aggregate share market, various
industries or individual securities and that these values
depend on underlying economic factors.
• Therefore, investors should determine the intrinsic value of
an investment asset
• If the market price differs from the estimated intrinsic value
by enough to cover transaction costs, you should take
appropriate action.
• Market price > Intrinsic value; do not buy or sell
• Market price < Intrinsic value, buy
Efficient Markets and Fundamental Analysis
• If you can do a superior job of estimating intrinsic value, you can
make superior market timing decisions and generate above-average
returns
• Intrinsic value analysis involves:
• Aggregate market analysis
• Industry and company analysis
• Estimating the relevant variables is as much an art and a product of
hard work as it is a science
• Successful investors must understand what variables are relevant to
the valuation process and have the ability and work ethic to do a
superior job of estimating these important valuation variables.
Efficient Markets and Portfolio Management
• Portfolio Managers with Superior Analysts
• Concentrate efforts in mid-cap shares that do not
receive the attention given by institutional portfolio
managers to the top-tier shares
• The market for these neglected shares may be less
efficient than the market for large well-known shares
Efficient Markets and Portfolio Management
• Portfolio Managers without Superior Analysts
• Determine and quantify your client's risk preferences
• Construct the appropriate portfolio
• Diversify completely on a global basis to eliminate all
unsystematic risk
• Maintain the desired risk level by rebalancing the
portfolio whenever necessary
• Minimise total transaction costs
Efficient Markets and Portfolio Management
• Efficient capital markets and a lack of superior analysts imply that
many portfolios should be managed passively to match the
aggregate market and minimise the costs of research and trading.
• Institutions created market (index) funds which duplicate the
composition and performance of a selected index series.
• These funds are exchange traded funds (ETFs) and are also
known in Australia as exchanged traded products (ETPs)
• Exchange-traded product directory:
https://www.asx.com.au/markets/trade-our-cashmarket/overview/etfs-and-other-etps/etp-directory
Tutorial Questions:
Chapter 6: Question 1,4,5 and 10
Problem 1 and 2