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Chapter 10

Chapter 10 Questions
  • What do we mean when we say that capital markets
    are efficient?
  • Why should capital markets be efficient?
  • What factors contribute to an efficient market?
  • Given the overall efficient market hypothesis
    (EMH), what are the three subhypotheses and what
    are the implications of each?

Chapter 10 Questions
  • How do we test the three efficient market
    subhypotheses, and what are the results of the
  • For each set of tests, which of the results
    support the EMH and which indicate an anomaly
    related to the hypothesis?
  • What is behavioral finance, and how does it
    relate to the EMH?

Chapter 10 Questions
  • What are some of the major findings of behavioral
    finance, and what are the implications for the
  • What are the implications of the efficient market
    test results for
  • Technical analysis?
  • Fundamental analysis?
  • Portfolio managers with superior analysts?
  • Portfolio managers with inferior analysts?

Efficient Capital Markets
  • In an efficient capital market, security prices
    adjust rapidly to the arrival of new information,
    therefore the current prices reflect all
    information about the security
  • Whether markets are efficient has been
    extensively researched and remains controversial

Why does it matter?
  • If prices do fully reflect all current
    information, it would not be worth an investors
    time to use information to find undervalued
  • If prices do NOT fully reflect information, FIND
    AND USE THAT INFORMATION, and perhaps you will be
    able to make a killing in the market.

Investing and Market Efficiency
  • Would stock selection amount to throwing darts at
    a wall in an efficient market?
  • Hardly! Risk still matters. We would still want
    to research the risk-return properties of

Why Should Capital Markets Be Efficient?
  • What would be the ingredients of an
    informationally efficient market?
  • A large number of profit-maximizing participants
    analyze and value securities
  • 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
  • Price adjustments are unbiased correct on
  • Under these conditions, a securitys price would
    be appropriate for its level of risk.

Alternative Efficient Market Hypotheses
  • The various forms of the efficient market
    hypothesis differ in terms of the information
    that security prices should reflect.
  • Weak-form EMH
  • Semistrong-form EMH
  • Strong-form EMH

Weak-Form EMH
  • Current prices fully reflect all security-market
    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

Implications of the Weak-From EMH
  • Examining recent trends in price and other market
    data in order to predict future price changes
    would be a waste of time if the market is
    weak-form efficient.
  • A lot of people do price charting and other forms
    of technical analysis.

Semistrong-Form EMH
  • Current security prices reflect all public
    information, including market and non-market
  • This implies that decisions made on new
    information after it is public should not lead to
    above-average risk-adjusted profits from those

Implications of the Semistrong-Form EMH
  • If the market is efficient in this sense,
    information in The Wall Street Journal, other
    periodicals, and even company annual reports is
    already fully reflected in prices, and therefore
    not useful for predicting future price changes.

Strong-Form EMH
  • Stock prices fully reflect all information from
    public and private sources
  • This would require perfect markets in which all
    information is cost-free and available to
    everyone at the same time (which is clearly not
    the case)
  • Implication Not even insiders would be able to
    beat the market on a consistent basis

Tests and Results Weak-Form EMH
  • Two Approaches
  • Tests of statistical memory in security prices
    and returns
  • Tests of trading rules

Tests and Results Weak-Form EMH
  • Statistical tests of independence between rates
    of return
  • Autocorrelation tests
  • Mostly support the weak-form EMH and indicate
    that price changes are random
  • Some studies using more securities and more
    complicated tests cast some doubt
  • Runs tests
  • Indicate randomness in prices

Tests and Results Weak-Form EMH
  • Comparison of trading rules to a buy-and-hold
  • Some filter rules seem yield above-average
    profits with small filters, but only before
    taking into account the substantial transactions
    costs involved
  • Trading rule results have been mixed, and most
    have not been able to beat a buy-and-hold policy

Tests and Results Weak-Form EMH
  • Problems with tests
  • Cannot be definitive since trading rules can be
    complex and there are too many to test them all
  • Testing constraints
  • Use only publicly available data
  • Should include all transactions costs
  • Should adjust the results for risk (an apparently
    successful strategy may just be a very risky

Conclusions Weak-Form EMH
  • Results generally support the weak-form EMH, but
    results are not unanimous
  • Some strategies too subjective to test
  • Not all trading rules are disclosed
  • If you had a trading strategy that worked, would
    you reveal it?!

Reality Check!
  • If someone writes a book on how to beat the
    market, you can bet that book sales are more
    lucrative than the trading strategy!
  • Even if it once worked, if its widely known, it
    wont work any more!
  • Dont quit your day job to trade on-line using a
    published strategy!

Tests and Results Semistrong-Form EMH
  • Three different groups of tests
  • Time series analysis using public information
  • Event studies examine how fast stock prices
    adjust to significant economic events
  • Cross-sectional analysis of returns based on
    public information
  • Tests involve the estimation of abnormal
    returns, where expected abnormal returns are
    zero in an efficient market.

Tests and ResultsSemistrong-Form EMH
  • Tests often involve market-adjusted returns,
    created by subtracting the market return from the
    securitys return, thereby defining a securitys
    abnormal return
  • ARit Rit - Rmt
  • where
  • ARit abnormal return on security i during
    period t
  • Rit return on security i during period t
  • Rmt return on a market index during period t

Tests and Results ofSemistrong-Form EMH
  • Another definition of abnormal return is a
    risk-adjusted return or market model which
    adjusts for the securitys own required rate of
    return, given its systematic risk (as measured by
  • ARit Rit - E(Rit)
  • where
  • E(Rit) the expected rate of return for stock i
    during period t based on the market rate of
    return and the stocks normal relationship with
    the market (its beta)

Tests and Results Semistrong-Form EMH
  • Time series tests for predictability of returns
    and profit opportunities
  • Short-horizon returns have shown very limited
  • Long-horizon returns analysis shown some
    predictability of returns based on
  • Dividend yield (D/P)
  • Default spread
  • Term structure spread

Tests and Results Semistrong-Form EMH
  • Time series tests for predictability of returns
    and profit opportunities
  • Quarterly earnings reports information
  • Unanticipated earnings changes or earnings
    surprises are not immediately reflected in
    security prices
  • The January Anomaly (A calendar effect)
  • Large returns in January present opportunities to
    purchase in December, and sell in January and
    earn abnormal returns.

Tests and Results Semistrong-Form EMH
  • Time series tests for predictability of returns
    and profit opportunities
  • Other calendar effects
  • Monthly effect
  • Day-of-the-week effects
  • Monday returns were significantly negative

Tests and Results Semistrong-Form EMH
  • Predicting cross-sectional returns
  • In an efficient market, all securities should
    have equal risk-adjusted returns
  • Studies examine alternative measures of size or
    quality as a tool to rank stocks in terms of
    risk-adjusted returns
  • These tests include a joint hypothesis of both
    market efficiency and the asset pricing model
    used to generate abnormal returns

Tests and Results Semistrong-Form EMH
  • Predicting cross-sectional returns
  • Price-earnings ratios
  • Examine historical P/E ratios and returns
  • Low P/E stocks had higher risk-adjusted returns
    than high P/E stocks
  • Publicly available P/E ratios could be used for
    abnormal returns
  • Price-earnings/Growth ratios
  • Mixed results

Tests and Results Semistrong-Form EMH
  • Predicting cross-sectional returns
  • The size effect
  • The risk-adjusted returns for extended periods
    indicate that the small firms consistently
    experienced significantly larger risk-adjusted
    returns than large firms
  • Abnormal returns could occur because either
    markets are inefficient or the market model is
    not properly specified and provides incorrect
    estimates of risk and expected returns (joint

Tests and Results Semistrong-Form EMH
  • Predicting cross-sectional returns
  • The size effect
  • Adjustments for riskiness of small firms did not
    explain the large differences in rate of return
  • The impact of transactions costs of investing in
    small firms is substantial (takes away the
    differential with a short-term trading strategy)
  • Even after risk and transaction costs, small
    firms outperform large firms with annual trading
  • The small-firm effect is not stable
  • Firm size is an important anomaly

Tests and Results Semistrong-Form EMH
  • Predicting cross-sectional returns
  • Neglected firms and trading activity
  • Is there an effect related to the number of
    analysts following a stock and how frequently a
    stock trades?
  • Mixed results, mostly any apparent effects
    explained by taking the size effect into

Tests and Results Semistrong-Form EMH
  • Predicting cross-sectional returns
  • Book value-market value (BV/MV) ratio
  • Significant positive relationship between the
    current values for this ratio and future stock
  • Although various measures including the P/E ratio
    seem to help predict future returns, the size
    effect and BV/MV ratio have the greatest
    predictive ability.

Tests and Results Semistrong-Form EMH
  • Event studies
  • Event studies examine abnormal returns
    surrounding various events
  • The EMH is that abnormal returns are zero
  • Stock split studies
  • Mostly show no positive impact on returns because
    of a stock split
  • Initial public offerings
  • Significant IPO underpricing, but with rapid
    adjustment, consistent with the EMH

Tests and Results Semistrong-Form EMH
  • Event studies
  • Exchange listings
  • Some evidence of short-term profit potential
    following the listing announcement
  • Unexpected world events and economic news
  • Quickly reflected in security prices, do not
    provide opportunities

Tests and Results Semistrong-Form EMH
  • Event Studies
  • Announcements of accounting changes
  • Quickly reflect in security prices and do not
    seem to provide abnormal profit opportunities
  • Corporate events
  • Prices react quickly to announcements of mergers,
    financing decisions, etc.
  • No systematic profit opportunities

Summary on the Semistrong-Form EMH
  • Evidence is mixed
  • Strong support of the EMH from numerous event
    studies with the exception of exchange listing
  • Strong evidence against the EMH from both time
    series and cross-sectional studies
  • Dividend yields, earnings surprises, calendar
  • The size effect, BV/MV, P/E ratios, etc.

Tests and Results Strong-Form EMH
  • Testing Groups of Investors
  • Tests usually center on whether any group of
    investors consistently earn abnormal profits.
  • Corporate insiders
  • Stock exchange specialists
  • Security analysts
  • Professional money managers

Tests and Results Strong-Form EMH
  • Corporate Insiders
  • Insiders include major corporate officers,
    directors, and owners of 10 or more of any
    equity class of securities
  • Insiders must report to the SEC each month on
    their transactions as insiders
  • These insider trades are made public about six
    weeks later and allow for study

Tests and Results Strong-Form EMH
  • Corporate Insiders
  • Mixed results
  • Corporate insiders generally experience
    above-average profits especially on purchase
  • This implies that many insiders had private
    information from which they derived above-average
    returns on their company stock
  • Later studies indicate that non-insiders who
    trade with insiders may no longer be able to
    generate abnormal returns

Tests and Results Strong-Form EMH
  • Stock Exchange Specialists
  • Specialists have monopolistic access to
    information about unfilled limit orders
  • You would expect specialists to derive
    above-average returns because of their superior
    information, and this appears to be the case.

Tests and Results Strong-Form EMH
  • Security Analysts
  • Tests have considered whether it is possible to
    identify a set of analysts who have the ability
    to select undervalued stocks
  • This looks at whether, after a stock selection by
    an analyst is made known, a significant abnormal
    return is available to those who follow their

Tests and Results Strong-Form EMH
  • Security Analysts
  • The Value Line Enigma
  • Firms ranked 1 for timeliness substantially
    outperform the market firms ranked 5
    substantially underperform the market
  • Prices now adjust quickly to changes in rankings
  • Net of transaction costs, rankings do not appear
    to have value in terms of producing abnormal
  • There is some evidence of superior analysts who
    apparently posses private information

Tests and Results Strong-Form EMH
  • Professional Money Managers
  • Trained professionals, working full time at
    investment management
  • If any investor can achieve above-average
    returns, it should be this group
  • If any non-insider can obtain inside information,
    it would be this group due to the extensive
    management interviews that they conduct

Tests and Results Strong-Form EMH
  • Professional Money Managers
  • Most tests examine mutual funds
  • Risk-adjusted returns of mutual funds generally
    show that most funds did not match aggregate
    market performance

Summary on the Strong-Form EMH
  • Mixed results
  • Some strong support
  • Professional money managers
  • Some strong evidence against the EMH
  • Tests for corporate insiders and stock exchange
    specialists do not support the hypothesis
  • Both groups seem to have monopolistic access to
    important information and use it to derive
    above-average returns

Behavioral Finance
  • A growing field of study in finance.
  • Rather than assuming ultra-rational behavior, the
    area of behavioral finance seeks to incorporate
    how humans actually behave.
  • Incorporates the ways in which psychology may
    impact investment decisions
  • It has been useful for explaining various
    anomalies that we observe in decision-making
    that are difficult to reconcile with rationality

Behavioral Finance
  • Using psychological biases to explain behavior
  • Why do investors persistently ride losers and
    sell winners?
  • Can be explained by prospect theory
  • Why do investors display overconfidence in
  • Can be explained by the confirmation bias
  • Why do investors tend to put more money into
    failing investments?
  • Can be explained by the escalation bias

Fusion Investing
  • Attempts to integrate two elements of investment
  • Fundamental value
  • Dominant factor
  • Investor sentiment
  • Additional demand factor related to fads and

Implications of Market Efficiency
  • Overall results indicate the capital markets are
    efficient as related to numerous sets of
  • There are substantial instances where the market
    fails to rapidly adjust to public information
  • So, what techniques will or wont work?
  • What do you do if you cant beat the market?

Efficient Markets and Technical Analysis
  • Assumptions of technical analysis directly oppose
    the notion of efficient markets
  • Technicians believe that stock prices move in
    patterns that persist and are predictable to the
    informed investor.
  • Technical analysts develop systems to detect
    trends and patterns in prices
  • If the capital market is weak-form efficient, a
    trading system that depends on past trading data
    can have no value

Efficient Markets and Fundamental Analysis
  • Fundamental analysis involves determining an
    investments intrinsic values based on company
    and economic fundamentals
  • The intrinsic value is compared to the market
    price to determine whether the investment is
    undervalued or overvalued
  • In an efficient market, prices already reflect
    public information, so determining intrinsic
    value using that information is not a worthwhile

Efficient Markets and Fundamental Analysis
  • Past vs. Future
  • The EMH, importantly, considers the incorporation
    of available information, which is primarily
    historic in nature.
  • Much of what is involved in fundamental analysis,
    including aggregate market analysis and industry
    analysis, involves estimating future values.
  • Superior analysts are those who will be better at
    predicting this uncertain future.

Efficient Markets and Portfolio Management
  • Does active portfolio management pay off?
  • Research indicates that most money managers do
    keep pace with the market
  • Certainly with a superior analyst,
    recommendations should be followed
  • Opportunities may be present in smaller,
    neglected stocks (although risk must be taken
    into account)

Efficient Markets and Portfolio Management
  • Without superior analysts, passive management may
    outperform active management
  • Build a globally diversified portfolio with a
    risk level matching client preferences
  • Minimize transaction costs (taxes, trading
    turnover, liquidity costs)

The Rationale and Use of Index Funds
  • Efficient capital markets and a lack of superior
    analysts imply that many portfolios should be
    managed passively (so their performance matches
    the aggregate market, minimizes the costs of
    research and trading)
  • Institutions created market (index) funds which
    duplicate the composition and performance of a
    selected index series

Insights from Behavioral Finance
  • There may be trading opportunities created by
    persistent investor biases and herd mentality
  • Supports the notion of contrarian investment
  • Some mutual funds employ behavioral finance

Efficiency in European Equity Markets
  • Hawawini study indicates behavior of European
    stock prices is similar to U.S. common stocks
  • Despite market differences, most results are
    essentially similar
  • Appropriate to assume a similar level of
    efficiency in European markets to those in the
    United States
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