Chapter 13
Efficient Capital Markets
Two Views on Capital Market Efficiency:
• “ . . . in price movements . . . the sum of every scrap of
knowledge available to Wall Street is reflected as far as the
clearest vision in Wall Street can see.”
Charles Dow, founder of Dow-Jones, Inc. and first editor of The
Wall Street Journal (1903)
• “In an efficient market, prices ‘fully reflect’ available
information.”
Professor Eugene Fama, financial economist (1976)
Jacoby, Stangeland and Wajeeh, 2000
1
Efficient Capital Markets
Capital Markets Informational Efficiency:
Asset prices fully reflect all relevant information.
Question: What is the set of “relevant information”?
Three Theories (Hypotheses)
• Markets are weak form efficient
• Markets are semistrong form efficient
• Markets are strong form efficient
Jacoby, Stangeland and Wajeeh, 2000
2
What is the set of “Relevant Information”?
3 Forms of Market Efficiency:
I Weak Form:
Relevant information includes just historical information
(e.g. historical prices, past dividends, etc...).
Implications:
– Security prices already reflect all historical info.
– We say that security prices follow a random walk (the
relationship between today’s price and yesterday’s price is
random).
– Knowing historical data cannot be used to price securities
more efficiently than the market.
– Investors can’t make abnormal profits using historical data.
Jacoby, Stangeland and Wajeeh, 2000
3
What is the set of “Relevant Information”?
II Semistrong Form:
Relevant information is all historical info + all relevant
public info (e.g. firm financial statements, dividend
announcements, inflation rates, etc..)
Implications:
– Security prices already reflect all that info.
– Knowing this info cannot be used to price securities more
efficiently than the market.
– Investors can’t make abnormal profits by using it.
Jacoby, Stangeland and Wajeeh, 2000
4
What is the set of “Relevant Information”?
IIIStrong Form:
Relevant information is all historical and public info + all
relevant private info (e.g. insider info).
Implications:
– Security prices already reflect all that info.
– Knowing this info cannot be used to price securities more
efficiently than the market.
– Investors can’t make abnormal profits by using it
Jacoby, Stangeland and Wajeeh, 2000
5
Relationship among Three Different Information Sets
All information
relevant to a stock
(inc. private info)
Information set
of publicly available
information
Information
set of
past prices
Jacoby, Stangeland and Wajeeh, 2000
6
Market Efficiency - Examples
Technical Analysts & Chartists
• Believe in weak form inefficiency:
They look for patterns in past stock prices and trading volumes,
in order to predict the (near) future and make abnormal returns
in the short-run.
• Fundamental Analysts
Believe in semistrong form inefficiency:
They make forecasts of future earnings and dividends, in order
to project future stock prices and returns.
• Insider Trading Violators
Believe in a strong form inefficiency.
Jacoby, Stangeland and Wajeeh, 2000
7
Efficient Capital Markets : Evidence & Findings
I Weak Form
Can you earn Abnormal Returns, using historical info?
Definition:
• Abnormal Returns (AR):
ARt = return in day t - normal return
Findings:
• In general the market is weak form efficient:
For daily returns - today’s excess return is not related to past
excess returns
r(ARt, ARt-1) = 0
• Evidence of Exceptions (Anomalies):
– For consecutive transactions: r(ARt, ARt-1)  0
– End of The Year effect: ARDec < 0 and ARJan > 0
– Friday The 13th effect: ARFri, 13 < 0
Jacoby, Stangeland and Wajeeh, 2000
8
II Semistrong Form
Do stock prices compound all public available info?
Events Studies Tests:
Examine Announcements of events known to have a price effect. If
the market is semistrong form efficient, prices will adjust immediately
Events & Findings:
AR  0
Dividend increase
Stock repurchase
AR  0
Floating new shares
AR  0
Takeover announcements (target firm)
AR  0
Insider holding increase
AR  0
Conclusion:
In general Markets are semi-strong form efficient
9
Reaction of Stock Price to New Info in Efficient and Inefficient Markets
Stock
Price ($)
Overreaction and
correction
Delayed reaction
Efficient market reaction
–8 –6 –4 –2
0
+2 +4 +6 +7
Days relative
to announcement day
Announcement day
Jacoby, Stangeland and Wajeeh, 2000
10
III Strong Form
Can private info be used to beat the normal return?
3 types of traders have been examined:
(a) Insiders (CEO`s, Board of Directors, large shareholders)
By law: cannot use confidential undisclosed info.
Findings:
• Insiders earn positive excess returns
(b) Stock Exchange Specialists
Earn abnormal returns consistently
(c) Mutual Fund & Pension Fund Managers
Do not outperform the normal returns.
Jacoby, Stangeland and Wajeeh, 2000
11
Implications of an Efficient Capital Market for Corporate
Financial Managers
 Financial managers cannot “fool” investors by changing accounting
practices
 Financial managers cannot “time” security sales
 There are no price pressure effects when a firm sells many
bonds/shares
Jacoby, Stangeland and Wajeeh, 2000
12