Chapter 5: The Efficient Market Hypothesis

Market Efficiency
Operational efficiency: Markets ability to carry out transactions quickly, cheaply and reliably Allocative efficiency: A situation where resources are allocated to their most productive uses Informational efficiency: The speed and accuracy with which markets incorporate new information into prices

EMH
EMH says that financial markets make best possible use of all available information EMH applies to all financial (and even to non-financial) markets

EMH
What does that mean by best use?
Best means quickly and completely so that all relevant information is incorporated into asset prices so quickly that no ones enjoy a sustained information advantage to earn abnormal rate of return on average Speed/completeness and correctness (incorporating information into the correct model of asset pricing)

EMH
Private information: Information that can only be obtained from the firm itself and cannot directly available to the public If strong form of EMH holds, there is no value in paying for analysts advice Insider trading: Trading of securities by individuals with potential access to non-public information about the company
In many countries, insider trading in financial markets is illegal Many economists argue that insider trading should NOT be prohibited because (i) the trade based on inside information will automatically releases that information to the market; (ii) insider trading are allowed elsewhere

EMH
Agents are:
rational self-interest

Rates of returns also incorporate all relevant information

EMH
D1 P 1 P0 1 K D1 P P0 K 1 P0 P0
Assume that the next dividend is known The rate of return, Ke, expected at the beginning of the period, is uncertain but can only form expectations of P1

EMH
Optimal forecast: A forecast that cannot be improved using the current data set best forecast based on current data EMH argues that people use all available information in forming future expectations of futures events then Ke is optimal forecast of K, P1e is optimal forecast of P1. Ke = K+ and P1e = P1+

EMH
Why do agents make optimal forecasts?
Equilibrium (required) return and price are K* and P* If optimal forecast of K exceeds the required rate of return, informed investors will buy the asset to benefit from abnormal return, causing the price to rise and forecast return to fall until the optimal forecast just equals the required or equilibrium return If optimal forecast of K is below the required rate of return, informed investors will sell the asset to avoid capital loss, causing the price to fall and forecast return to rise until the optimal forecast just equals the required or equilibrium return K K P K

K K P K

EMH
Agents may not always succeed in making optimal forecasts
Firstly, EMH does not say that people use all information in forming their expectations because information is NOT costless => EMH implies that prices reflect all information whose marginal cost is less than marginal benefit from incorporating it in the decision

EMH
Secondly, EMH does not require everyone to behave as well-informed, rational, risk adverse wealth maximisers. Market prices are determined by the actions of the majority. While some of the investors may not be well-informed (noise traders), their irrational trades cancel (decisions of noisetraders are uncorrelated) and leave price and return to be determined by rational and well-informed investors. Even if noise-traders do behave in the same way (their decisions are correlated and they reinforce each other rather than cancelling), opportunities for arbitrage will force noise-traders out of business

EMH
Thirdly, EMH does not say that prices will always be correct. It merely says that peoples expectations are the best possible forecasts in the prevailing situation. It is frequently the case that: P1+ = P1 + where is an error term What EMH does say is that there is nothing in the behavior of the error term which enables us to improve our forecasts. In other words, the forecast errors have a zero mean and they have zero covariance with the forecast.

Using the Information

Relevant information referred to in the EMH is information relating to fundamentals However, investors can use information that has nothing at all to do with fundamentals.
Ex: Bigger fool hypothesis there is always someone prepared to pay a higher price whatever the fundamentals may be. Those include investors who buy because prices are rising, regardless of what the fundamentally correct price may be

Implications of EMH
Firstly, firms should concentrate on organic growth rather than takeovers. There is no point in firms trying to manipulate information Secondly, if semi-strong form EMH holds, there is no advantage to the individual investor in monitoring public information since others already do so => free-rider problem. But if all investors opt out of the price discovery process, no one will do so. It is the belief that there may be a small change if beating the market that keep free-rider problem at bay and, in so doing, makes the market efficient

Implications of EMH
Thirdly, share prices will only be changed by new information which comes to the market randomly Fourthly, if the market is strong form efficient (it is not possible for anyone to beat the market), it is not clear why it is worth paying for professional fund management. (There still be the benefits of lower transaction cost and diversification) Finally, the best strategy is a diversified buy and hold strategy

Evidence of Informational Efficiency

Booms and crashes: If EMH holds, it is difficult to explain the booms and crashes, such as US Wall Street boom and crash in 1929, the dot-com bubble of 1995-2000 and the crisis of 2008

Evidence of Informational Efficiency

FTSE-100 Index 2006 - 2011

Evidence of Informational Efficiency

FTSE-100 reduced 43% from October 1999 - October 2002 and from August 2007 March 2009. The upswings of similar amplitude (from about 4000 to 7000) prior to the crashes are more gentle but still quite rapid. On the basis of fundamentals, these rapid decrease and increase require large change in terms of risks and productivity of UKs firm, which are not likely. In the case of 2008, the fall may be justifiable because firms, especially financial firms, became much more riskier. But there is still the problem why the risk was not spotted in the upswing.

Behavioral Finance
Behavioral finance considers how various psychological traits affect the way that individuals or groups act as investors, analysts, and portfolio managers Because of the costs and difficulties of acquiring information, investors may give up the effort at quite early stage and rely on rules of thumb or heuristics (experience) with the result that prices/returns may behave quite strangely

Behavioral Finance
Conservatism: Investors have a particular view about a company and the value of its stock. They then receive the news about the firm but underreact to the news. But the new keeps coming and eventually they overreact by considering the news as part of a trend which is going to continue forever

Behavioral Finance
Representativeness: If news recurs often enough, it is treated as belonging to a pattern and the possibility of randomness is discounted

The Failure of Arbitrage

Arbitrage involves the simultaneous purchase and sale of the same asset in two different markets at advantageous prices, thus making riskless profits Arbitrage is an important underpinning of the law of one price Noise-traders will be the ones who are buying overpriced securities sold by arbitrageurs and selling the underpriced securities to them, making noise-traders lose their wealth and will be forced out of the market

The Failure of Arbitrage

The failure of arbitrage:
There is often no (underpriced) close substitute available for the asset which is overpriced Timing problem: The risk that prices which are expected to converge eventually might diverge before the deal has to be closed