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Lecture 1 Effecient Market Hypothesis

Lecture 1 Effecient Market Hypothesis

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Published by: Information should be FREE on Oct 07, 2010
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Investment Management and Capital Markets
Lecture 1: The EMH, Technical and Fundamental Analysis
The efficient market hypothesis
Techniques of Technical analysis
Techniques of Fundamental analysis
Background to the EMH
The Mechanistic Hypothesis (MH):
The EMH is one of the central theories in Modern Finance.
Upto about the end of the sixties, it was believed that the market price of a share
was directly influenced by
- published accounting statements and
- management announcements on operational results
This was called the `Mechanistic hypothesis.’
( Also the `Classical Hypothesis.’)
However, the general difference between Book and Market Values prompted
researchers to develop and test alternative theories.
Two important studies in this connection were the Ball and Brown study (1968)
and the Kaplan and Roll study (1972).
Two important studies in this connection were the Ball and Brown study (1968)
and the Kaplan and Roll study (1972).
(1) Ball and Brown (1968).
Firms were partitioned into good news firms and bad news firms according to whether
the reported earnings was above or below a time series forecast.
(2) Kaplan and Roll (1972):
This study tested the stockmarket’s reading of an accounting change which changed the
reported earnings but had no effect on cash flow.
(3) Sunder (1973) studied the share price performance of companies which changed their
inventory accounting policies from LIFO to FIFO and vice versa. A shift from FIFO to
LIFO improves cashflow and a shift from LIFO to FIFO improves eps. If investors
valued cashflow and not eps then a shift from FIFO to LIFO should result in a share price
Implications: if the MH is valid then prices should react abnormally upon publicizing the
accounts in each case.
Actual findings:
The Ball and Brown study found:
- good news firms and bad news firms showed abnormally positive or negative returns
(as measured by ei) which started building up upto 12 months before the announcement;
- 80-85% of the abnormal reaction occurred prior to the announcements implying that the
actual announcements had virtually no impact.
The Kaplan and Roll study found:
on study of a 60 week period, 30 weeks before the announcement and 30 weeks after the
- the abnormal return immediately after the announcement was insignificant from 0;
- moreover after week 36, a pronounced negative abnormal return was noticed.
The Sunder study found:
That firms shifting to LIFO had shown an abnormal rise of 5% in the 12 month period
before the switch and firms switching to FIFO showed a fall of about 10% in the year
after the switch.
These studies seemed to imply that accounting statements of a company were not the
sole basis on which share prices responded, and thus did not support the Mechanistic
What factors could then influence share prices?
These results supported the alternative hypothesis of an efficient market which built in
the economic value of information based on its availability from a variety of other
such as:- the state of the entire economy
- the outlook for the specific industry the firm was in
- news on the firm from government reports,
- industry association reports, analysts’ reports
- perceived changes in the firm’s cash flow
- market information on the firm’s prospects
all influence share movements.
The Efficient Market Hypothesis
Studies such as the above led to the formal development of the ` Efficient Market
In a market economy, the concept of capital market efficiency can be looked at in three
different ways:
- allocative efficiency refers to the ability of the market to allocate resources effectively
- operational efficiency implies the ability of the market to work on low transaction costs
- informational efficiencyrefers to the ability of the market to correctly reflect via
security prices, the value of information.
The Efficient Market Hypothesis refers to informational efficiency and can be stated as:
“ in an efficient market share prices reflect the value of all relevant information.”
The assumptions to the efficient market hypothesis are the same for perfect capital
- information freely and instantaneously available to all
- homogeneous products being traded
- no taxes
- perfect competition
- costless transactions
An important part of the concept of Market Efficiency is what type of information
and how quickly the value of relevant information gets reflected in share prices.
Thus three forms of market efficiency have been defined:

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