# Efficient market hypothesis

Assistant Professor um IMS Unison University
9. Mar 2021
1 von 17

### Efficient market hypothesis

• 2. What is an Efficient Market? • An efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic value. • Note that market efficiency does not imply that the market price equals intrinsic value at every point in time. It means, the errors in the market prices are unbiased. This means that the price can deviate from the intrinsic value but the deviations are random and uncorrelated with any observable variable. • If the deviations of market price from intrinsic value are random, it is not possible to consistently identify over or under-valued securities. • In a article, titled “Noise,” (July 1986), Fischer Black defines an efficient market as one in which the price is more than half of value and less than two times the value. According to him, by this definition almost all markets are efficient at least 90 percent of the time. Intrinsic value of an asset usually refers to a value calculated on simplified assumptions.
• 3. Foundations of Market Efficiency • According to Andrei Shleifer, any one of the following three conditions will lead to market efficiency: (I) investor rationality, (II) independent deviation from rationality, and (III) effective arbitrage. • (I) Investor Rationality :- If all investors are rational, stock prices will adjust rationally to the flow of new information. Suppose Dr. Reddy’s Laboratories announces an acquisition. If investors understand fully the implications of the acquisition for the value of the company and act rationally, the stock price of Dr. Reddy’s Laboratories will quickly reflect this piece of information. • (II) Independent Deviation from Rationality :- Suppose the announcement of acquisition by Dr. Reddy’s Laboratories is not understood by most investors. As a result, some may react in an overly optimistic manner while others may react in an overly pessimistic manner. As long as the deviations from rationality are independent and uncorrelated, errors tend to cancel out and the market price will still be an unbiased estimate of intrinsic value.
• 4. • (III) Effective Arbitrage :- Let us assume that there are two types of market participants, viz., irrational amateurs and rational professionals. • Irrational amateurs are driven by emotions. At times they become euphoric and push prices to dizzy heights and at times they become depressed and drive down prices to unreasonably low levels • What happens when the market is thronged by rational professionals as well? Rational professionals are supposed to value companies in a thorough and methodical fashion and assess evidence fairly objectively. Based on their analysis, they will take actions to exploit mispricing of securities caused by the behaviour of irrational amateurs. If they find that Tata Motors is overpriced relative to Maruti Suzuki they will sell Tata Motors and buy Maruti Suzuki.
• 5. Efficient Market Hypothesis (EMH) • The Efficient Market Hypothesis (EMH) is a theory that the price of a security reflects all currently available information about its economic value. • A market in which prices fully reflect all available information is said to be efficient. • The concept is important for investment management because it serves as a guide to expectations about the potential for profitable trading, the likelihood of finding an investment manager who can beat the market, and the limits of predictability in the capital markets. If the theory is precisely true, it is impossible for a speculator, an investment manager, or the clients of the manager to consistently beat the market. • The intuition underlying the EMH is the invisible hand of the marketplace. In a quest for profits, competition among speculators to buy undervalued assets or sell overvalued assets will quickly drive expected gains to trade to zero. • The statement that prices “reflect all available information” implies that no trader has any kind of informational advantage in the security markets. If this is so, then the price today reflects the common or “market” expectation of what the security would be worth tomorrow.
• 6. Assumptions of EMH • Market is supreme and no individual investor or group can influence it. • All investors have the same information and nobody has to prior knowledge. • Stock prices discount all the information quickly. • Institutional investors or measure fund managers have to follow the market and cannot influence it. • Transaction cost is not present. • Taxation have no impact on investment policy. • Every investor borrow or lend at same rate.
• 7. FORMS OF EFFICIENT MARKET HYPOTHESIS • The early work on efficient capital markets focused mainly on the empirical analysis in support of random walk hypothesis, without much underlying theory. • In 1970, Eugene Fama organised the growing empirical evidence and presented the theory in terms of a fair game model, arguing that the current price of a security fully reflects all available information. • As a result, its expected return would be consistent with its risk. • Eugene Fama suggested that it is useful to describe three forms of efficient market hypothesis (EMH): (I) Weak-form EMH, (II) Semistrong-form EMH, and (III) Strong-form EMH.
• 8. • The weak-form EMH asserts that security prices fully impound all security market information relating to prices, trading volumes, rates of return, block trades, insider transactions, odd-lot transactions, and so on. • It assume that after the announcement, the price gradually increases over the week in response to the announcement. Investors examining the price sequence would observe that the price was moving away from that level at which it had previously traded. • If they purchased securities when the securities started to trade away from historical prices, they would purchase the security a day or two after the announcement (after they had observed this new price behaviour). Weak-Form Efficient Market Hypothesis
• 9. • If it took a week for the price to fully reflect the announcement, however, investors purchasing securities on the basis of movements away from historical prices would benefit from part of the price increase and make excess returns. • Tests of the predictability of returns (formerly tests of the weak form of the EMH) are in part tests of whether this type of trading behaviour can lead to excess profits. • If returns are not predictable from past returns, then new information is incorporated in the security price sufficiently fast that, by the time an investor could tell from the price movements themselves that there had been a fundamental change in company prospects, the fundamental change is already fully reflected in price.
• 10. Semistrong-Form Efficient Market Hypothesis • The semistrong-form EMH argues that the security prices fully reflect all public information. They reflect market information (so, the weak-form EMH is subsumed under semistrong-form EMH) as well as non-market information such as macroeconomic data, industry reports, corporate announcements, price-earning ratios, price-book value ratios, dividend yields, and so on. • Assume the investor hears the announcement of the improved prospects and believes it. The investor immediately buys shares of the company in anticipation of a price rise. • The semistrong-form tests of the EMH are tests of whether this strategy leads to excess profits.
• 11. • The semistrong form of the EMH assumes that investors who wish to sell the security, as well as those who wish to buy, hear the announcement and reassess the value of the security. • This reassessment leads to an immediate increase in price. The new price need not be the new equilibrium price, but it is not systematically lower or higher than the equilibrium price. Thus an investor who buys the security after the announcement may be paying too little or too much for the security. • If the semistrong form of the EMH holds, then over a large number of similar situations the investor would be paying on average about what the securities are worth. The investor would be unable to earn an excess profit by purchasing securities on the basis of such announcements.
• 12. Strong-Form Efficient Markets Hypothesis • The strong-form EMH contends that security prices reflect all available information, public as well as private. • So, the strong-form EMH subsumes both the weak-form EMH and semistrong-form EMH. The strong-form EMH implies that no group of investors has monopolistic access to information which enables it to earn superior risk-adjusted returns. • The strong form of the EMH is concerned with two different ideas. Both can be demonstrated in terms of our previous example. • One idea involves whether anyone can earn money by acting on the basis of information such as the announcement discussed earlier. Tests of the semistrong form of the EMH would examine all announcements such as the one under discussion, assume an investor purchased immediately after the announcement, and see if this leads to excess returns.
• 13. • Assume the investor hears the announcement and can fairly accurately reassess its effect on the value of the company. When the price after the announcement is below the reassessed value, the investor purchases; when it is above, the investor sells if the shares are owned or shorts the stock (or does nothing) if the shares are not owned. • The strong form of the EMH states that there is no investor with this superior ability. • Because it is impossible to determine exactly how investors might utilize the announcement to reassess the value of the firm, tests of the strong form of the EMH are examinations of whether an investor or groups of investors have earned excess returns. Because of the lack of data on most types of investors, the group most frequently tested is managers of mutual funds.
• 14. • The strong form of the EMH has a second fact that can also be illustrated with this example. Suppose the managers of the firm knew about the improved prospects in advance of the announcement; they had access to the information before it was publicly available. • Could they purchase the security on the basis of the private information and make money? The most extreme form of the strong form of the EMH says no. It should not surprise the reader that the evidence does not support this extreme form of the EMH. What might surprise the reader, initially, is the strength of the evidence in favour of the less extreme forms. • Once the reader considers the ideas behind these hypotheses, however, it should not be as surprising. Information about securities is rapidly disseminated. There are thousands of people who follow securities professionally. Information should be rapidly incorporated in price
• 15. Misconceptions about the Efficient Market Hypothesis The efficient market hypothesis has often been misunderstood. The common misconceptions about the efficient market hypothesis are stated below along with the answers meant to dispel them. Misconception : The efficient market hypothesis implies that the market has perfect forecasting abilities. Answer : The efficient market hypothesis merely implies that prices impound all available information. This does not mean that the market possesses perfect forecasting abilities. Misconception : As prices tend to fluctuate, they would not reflect fair value. Answer : Unless prices fluctuate, they would not reflect fair value. Since the future is uncertain, the market is continually surprised. As prices reflect these surprises they fluctuate. Misconception : Inability of institutional portfolio managers to achieve superior investment performance implies that they lack competence. Answer : In an efficient market, it is ordinarily not possible to achieve superior investment performance. Market efficiency exists because portfolio managers are doing their job well in a competitive setting. Misconception : The random movement of stock prices suggests that the stock market is irrational. Answer : Randomness and irrationality are two different matters. If investors are rational and competitive, price changes are bound to be random.
• 16. SUMMARY  In the mid-1960s Eugene Fama introduced the idea of an “efficient” capital market. The efficient market hypothesis says that the intense competition in the capital market leads to fair pricing of securities. A sweeping statement, it continues to stimulate insight and controversy even today. Eugene Fama suggested that it is useful to distinguish three levels of efficiency: weak-form, semistrong - form, and strong-form. The weak-form efficient market hypothesis says that the current price of a stock reflects all information found in the record of past prices and volumes. By and large the empirical evidence, relying on tests like the serial correlation test, runs test, and filter rules test, supports the weak- form efficiency. The semistrong - form efficient market hypothesis holds that stock prices rapidly adjust to all publicly available information. Two kinds of studies have been conducted to test the semistrong - form efficient market hypothesis: event studies and portfolio studies.
• 17.  An event study examines the market reactions to and excess returns around a specific information event like an earnings announcement or a stock split. A portfolio study examines the returns earned by a portfolio of stocks having some observable characteristic like low price-earnings multiple. The results of event studies as well as portfolio studies are mixed.  The strong-form efficient market hypothesis holds that all available information, public or private, is reflected in stock prices. Obviously, this represents an extreme hypothesis and we would be surprised if it were true. Empirical evidence too does not support it.  Apart from the tests for various forms of market efficiency, many other studies have been done to explore the behaviour of security prices and interest rates. These studies suggest that the markets overreact, anomalies exist, stock prices are too volatile (compared to dividends), and interest rates move within a normal range.  The advocates of efficient market hypothesis argue that it is not surprising that several anomalies and puzzles have been found. When data is mined extensively, one is bound to find a number of patterns. Even if inefficiencies exist, it is difficult to take advantage of them.  The efficient market hypothesis, like all theories, is an imperfect and limited description of the stock market. However, at least for the present, there does not seem to be a better alternative.