Week 5
GD31403
Efficient Capital Markets
Why Should the Markets Be Efficient?
• Premises of An Efficient Market
– A large number of competing profit-maximizing
participants analyze and value securities, each
independently of the others
– New information regarding securities comes to the
market in a random fashion
– Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
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Why Should the Markets Be Efficient?
• The Results
– 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 stock should be consistent
with the perceived risk of the stock
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Efficient Market Hypotheses (EMH)
• Random Walk Hypothesis
– Changes in security prices occur randomly
• Fair Game Model
– Current market price reflect all available
information about a security and the expected
return based upon this price is consistent with
its risk
• Efficient Market Hypothesis (EMH)
– Divided into three sub-hypotheses depending
on the information set involved (Fama, 1970).
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EMH in Fama (1970)
(1) Weak-Form EMH
– Current prices reflect all security-market historical
information, including the historical sequence of
prices, rates of return, trading volume data, and
other market-generated information
– This implies that past rates of return and other
market data should have no relationship with
future rates of return
– In short, prices reflect all historical information
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EMH in Fama (1970)
(2) Semi-strong Form EMH
– Current security prices reflect all public
information, including market and non-market
information
– This implies that decisions made on new
information after it is public should not lead to
above-average risk-adjusted profits from those
transactions
– In short, prices reflect all public information
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EMH in Fama (1970)
(3) Strong-Form EMH
– Stock prices fully reflect all information from public
and private sources
– This implies that no group of investors should be
able to consistently derive above-average riskadjusted rates of return
– This assumes perfect markets in which all
information is cost-free and available to everyone
at the same time
– In short, prices reflect all public & private
information
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EMH in Fama (1970)
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Weak:
How well do past returns predict future returns?
Semi-strong: How quickly do stock prices reflect public information
announcement?
Strong:
Do any investors have private information that is not fully
reflected in market price?
Tests of Weak-Form EMH
(1) Statistical Tests of Independence
– Determine whether the asset prices follow a
random walk, or more strictly a martingale.
– Numerous statistical tests have been employed,
e.g.
• Autocorrelation tests
• Runs tests
• Long memory tests
• Non-linearity tests
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For a review of the statistical tests, see the
survey paper by Lim and Brooks (2011, JES)
Tests of Weak-Form EMH
(2) Profitability of Technical Trading Rules
– Almost infinite number of trading rules
– The most common one is filter rules
– Use only publicly available data
– Include transaction costs (the emphasis is on
profitability and not predictability)
– Adjust the results for risk
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For a review, see the survey paper by Park and
Irwin (2007, JES)
Tests of Semi-strong Form EMH
Event Studies
– Examine how fast stock prices adjust to specific
significant
economic
events
or
public
announcements.
– E.g., stock splits, initial public offerings, stock
listings, merger & acquisitions, earnings, spinoffs,
accounting changes.
– If the market is efficient, it would not be possible for
investors to derive positive abnormal returns by
investing
after
the
release
of
public
announcement.
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Tests of Semi-strong Form EMH
Individual Abnormal Returns Surrounding the
Event in an Efficient Market
-t
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0
Announcement Date
= abnormal return
+t
Tests of Semi-strong Form EMH
Individual Abnormal Returns Surrounding the
Event in an Inefficient Market
-t
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0
Announcement Date
+t
Tests of Semi-strong Form EMH
Abnormal Return (AR)
= Actual Return – Expected Return
rt = a + b(rindex,t) + et
AR = et
= rt – [a + b(rindex,t)]
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Tests of Semi-strong Form EMH
In this case there appears to be information leakage before the announcement date (day 0), but
markets adjust quickly.
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Tests of Semi-strong Form EMH
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Tests of Strong-Form EMH
• Strong-form EMH contends that stock prices
fully reflect both public and private information
• This implies that no group of investors with
private information will consistently earn
above-average profits
• Targeted groups of investors:
–
–
–
–
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Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
EMH in Fama (1991)
(1) Tests for Return Predictability (formerly
Weak-form EMH)
– The coverage was expanded beyond past returns.
– Include other forecasting variables like dividend
yields, earnings yields, interest rates, bond credit
spreads.
– Examine seasonality in returns like Monday Effect,
January Effect, Holiday Effect.
– Consider cross-sectional predictors such as bookto-market ratio, size, price-earnings ratio,
leverage, liquidity.
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EMH in Fama (1991)
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EMH in Fama (1991)
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EMH in Fama (1991)
(2) Event Studies (formerly Semi-strong form
EMH)
– Same coverage.
– Only a change in title.
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EMH in Fama (1991)
(3) Tests for Private Information (formerly
Strong-form EMH)
– Same coverage.
– Only a change in title.
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Implications of Efficient Capital Markets
• Overall, the results of many studies indicate the
capital markets are efficient as related to
numerous sets of information
• On the other hand, there are substantial
instances where the market fails to rapidly
adjust to public information
• What are the implications for investors in light
of these mixed evidence?
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– Technical Analysis
– Fundamental Analysis
– Portfolio Management
Implications of Efficient Capital Markets
(1) Technical Analysis
• Assumptions of technical analysis directly
oppose the notion of efficient markets
• 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
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• Technicians also believe that investors do not
analyze information and act immediately
Implications of Efficient Capital Markets
• Stock prices move to a new equilibrium after
the release of new information in a gradual
manner, causing trends in stock price
movements that persist for periods of time
• Technical analysts develop systems to detect
movement to a new equilibrium (breakout) and
trade based on that
• If the capital market is weak-form efficient, a
trading system that depends on past trading
data has no value
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Implications of Efficient Capital Markets
(2) Fundamental Analysis
• Fundamental analysts believe that there is a
basic intrinsic value for the aggregate stock
market, various industries, or individual
securities and these values depend on the
underlying economic factors
• Investors should determine the intrinsic value
of an investment at a point in time and
compare it to the market price
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Implications of Efficient Capital Markets
• 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
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Implications of Efficient Capital Markets
• If intrinsic value > current stock price:
- BUY
• If intrinsic value < current stock price
- SELL
• In either case if the analysis is correct, the
investor should receive an abnormal return.
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Implications of Efficient Capital Markets
• If the markets are only weak-form efficient,
fundamental analysis CAN yield abnormal
returns.
• If the markets are semi-strong or strong form
efficient, then fundamental analysis CANNOT
yield abnormal returns.
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Implications of Efficient Capital Markets
(3) Portfolio Management
• Active Management
– Security analysis
– Timing strategies
– Investment Newsletters
• Passive Management
– Buy and Hold portfolios
– Index Funds
Assumes inefficiency,
use technical and/or
fundamental analysis to
pick securities
Consistent with semistrong efficiency
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Implications of Efficient Capital Markets
Even if the market is efficient, a role exists for
portfolio management
– 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
– Minimize total transaction costs
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– Create market (index) funds which duplicate the
composition and performance of a selected index
series
Behavioral Finance
• It is 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
• There is no unified theory of behavioral
finance and the emphasis has been on
identifying portfolio anomalies that can be
explained by various psychological traits
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Behavioral Finance
Prospect Theory
• Contends that utility depends on deviations from moving
reference point rather than absolute wealth
Overconfidence (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
Escalation Bias
• Put more money into a bad investment
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Behavioral Finance
Fusion Investing
• The integration of two elements of investment
valuation: fundamental value & 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
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Adaptive Markets Hypothesis (AMH)
• With the issue of rationality in human
behaviour at the heart of the controversy
between the opposing camps of EMH and
behavioural finance, Lo (2004) argues that
valuable insights can be derived from the
biological perspective and calls for an
evolutionary alternative to market efficiency.
• Lo (2004) proposes the new paradigm of AMH
in which the EMH can co-exist alongside
behavioural finance in an intellectually
consistent manner.
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Adaptive Markets Hypothesis (AMH)
Implications of AMH to portfolio management
• The equity risk premium varies over time according to the
recent stock market environment and the demographics of
investors in that environment.
• Arbitrage opportunities do arise in the financial markets
from time to time.
• Investment products undergo cycles of superior and inferior
performance in response to changing business conditions,
the adaptability of investors, the number of competitors in
the industry and the magnitude of profit opportunities
available.
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• Survival is ultimately the only objective that matters for the
evolution of markets and financial technologies.
Adaptive Markets Hypothesis (AMH)
Conceptual Papers on AMH
Lo, A.W. (2004) The adaptive markets hypothesis: market
efficiency from an evolutionary perspective. Journal of
Portfolio Management 30(5): 15–29.
Lo, A.W. (2005) Reconciling efficient markets with
behavioral finance: the adaptive markets hypothesis.
Journal of Investment Consulting 7(2): 21–44.
Survey Paper on AMH
Lim, K.P. and Brooks, R.D. (2011) The evolution of stock
market efficiency over time: a survey of the empirical
literature. Journal of Economic Surveys 25(1), 69–10.
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Adaptive Markets Hypothesis (AMH)
Empirical Papers on AMH
Neely, C.J., Weller, P.A. and Ulrich, J. (2009) The adaptive
markets hypothesis: evidence from the foreign exchange
market. Journal of Financial and Quantitative Analysis
44(2), 467–488.
Kim, J.H., Shamsuddin, A. and Lim, K.P. (2011) Stock return
predictability and the adaptive markets hypothesis:
evidence from century-long U.S. data. Journal of
Empirical Finance 18(5), 868-879.
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Charles, A. Darne, O. and Kim, J.H. (2012) Exchange rate
return predictability and adaptive markets hypothesis:
evidence from major foreign exchange rates. Journal of
International Money and Finance, forthcoming.