Chapter 9

The Capital Markets and Market Efficiency

The notion that science, left to itself, is bound to evolve more and more of the truth about the world is another illusion, for science can never exist outside a society, and that society, whether deliberately or unconsciously, directs its course. - Northrop Frye

Outline
 Introduction

of the capital markets  Efficient market hypothesis  Anomalies

 Role

Introduction
 Capital

market theory springs from the notion that:

People like return People do not like risk Dispersion around expected return is a reasonable measure of risk
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Role of the Capital Markets

 Definition  Economic

function  Continuous pricing function  Fair price function

Definition
 Capital

markets trade securities with lives of more than one year of capital markets

 Examples

New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Chicago Board of Trade Chicago Board Options Exchange (CBOE)
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Economic Function
 The

economic function of capital markets facilitates the transfer of money from savers to borrowers
E.g., mortgages, Treasury bonds, corporate stocks and bonds

Continuous Pricing Function

 The

continuous pricing function of capital markets means prices are available moment by moment
Continuous prices are an advantage to investors Investors are less confident in their ability to get a quick quotation for securities that do not trade often
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Fair Price Function

 The

fair price function of capital markets means that an investor can trust the financial system
The function removes the fear of buying or selling at an unreasonable price The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price
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Efficient Market Hypothesis

 Definition  Types

of efficiency  Weak form  Semi-strong form  Strong form  Semi-efficient market hypothesis  Security prices and random walks
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Definition
 The

efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair
The EMH is perhaps the most important paradigm in finance

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Types of Efficiency
 Operational

efficiency measures how well things function in terms of speed of execution and accuracy
It is a function of the number of order that are lost or filled incorrectly It is a function of the elapsed time between the receipt of an order and its execution
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Types of Efficiency (contd)

 Informational

efficiency is a measure of how quickly and accurately the market reacts to new information
It relates directly to the EMH The market is informationally very efficient
Security prices adjust rapidly and accurately to new information The market is still not completely efficient
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Weak Form
 Definition  Charting  Runs

test

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Definition
 The

weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past
The current price is a fair one that considers any information contained in the past price data Charting techniques or of no use in predicting stock prices
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Definition (contd)
Example
Which stock is a better buy?
Stock A Current Stock Price Stock B

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Definition (contd)
Example (contd)
Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

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Charting
 People

who study charts are technical analysts or chartists

Chartists look for patterns in a sequence of stock prices Many chartists have a behavioral element

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Runs Test
A

runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance
A run is an uninterrupted sequence of the same observation A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number
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Conducting A Runs Test

Rx Z! W where R ! number of runs 2n1n2 x! 1 n1  n2 W! 2n1n2 (2n1n2  n1  n2 )

n1  n2

(n1  n2  1)

n1 , n2 ! number of observations in each category Z ! standard normal variable

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Semi-Strong Form
 The

semi-strong form of the EMH states that security prices fully reflect all publicly available information
E.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

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Semi-Strong Form (contd)

 Academic

research supports the semi-strong form of the EMH by investigating various corporate announcements, such as:
Stock splits Cash dividends Stock dividends

 This

means investor are seldom going to beat the market by analyzing public news
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Strong Form
 The

strong form of the EMH states that security prices fully reflect all public and private information  This means even corporate insiders cannot make abnormal profits by using inside information
Inside information is information not available to the general public
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Semi-Efficient Market Hypothesis

 The

semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others
Less well-known companies are less efficiently priced The market may be tiered A security pecking order may exist
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Security Prices and Random Walks

 The

unexpected portion of news follows a random walk

News arrives randomly and security prices adjust to the arrival of the news
We cannot forecast specifics of the news very accurately

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Anomalies
 Definition  Low

PE effect  Low-priced stocks  Small firm effect  Neglected firm effect  Market overreaction  January effect
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Anomalies (contd)
 Day-of-the-week

effect  Turn-of-the calendar effect  Persistence of technical analysis  Chaos theory

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Definition
A

financial anomaly refers to unexplained results that deviate from those expected under finance theory
Especially those related to the efficient market hypothesis

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Low PE Effect
 Stocks

with low PE ratios provide higher returns than stocks with higher PEs by several academic studies

 Supported

 Conflicts

directly with the CAPM, since study returns were risk-adjusted (Basu)
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Low-Priced Stocks
 Stocks

with a low stock price earn higher returns than stocks with a high stock price is an optimum trading range

 There

 Every

stock with a high stock price should split

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Small Firm Effect

 Investing

in firms with low market capitalization will provide superior riskadjusted returns by academic studies

 Supported  Implies

that portfolio managers should give small firms particular attention

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Neglected Firm Effect

 Security

analysts do not pay as much attention to firms that are unlikely portfolio candidates that neglected firms may offer superior risk-adjusted returns

 Implies

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Market Overreaction
 The

tendency for the market to overreact to extreme news

Investors may be able to predict systematic price reversals

 Results

because people often rely too heavily on recent data at the expense of the more extensive set of prior data
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January Effect
 Stock

returns are inexplicably high in January firms do better than large firms early in the year pronounced for the first five trading days in January
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 Small

 Especially

January Effect (contd)

 Possible

explanations:

Tax-loss trading late in December (Branch) The risk of small stocks is higher early in the year (Rogalski and Tinic)

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Types of Firms in January

January return S&P 500 Companies Highly Researched Moderately Researched Neglected Non-S&P 500 Companies Neglected 11.32% 10.72% 7.71%
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January return minus average monthly return in rest of year

January return after adjusting for systematic risk

2.48% 4.95% 7.62%

1.63% 4.19% 6.87%

-1.44% 1.69% 5.03%

Day-of-the-Week Effect
 Mondays

are historically bad days for the stock market and Fridays are consistently

 Wednesday

good
 Tuesdays

and Thursdays are a mixed bag

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Day-of-the-Week Effect (contd)

 Should

not occur in an efficient market

Once a profitable trading opportunity is identified, it should disappear

 The

day-of-the-week effect continues to persist

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Turn-of-the-Calendar Effect
 The

bulk of returns comes from the last trading day of the month and the first few days of the following month the rest of the month, the ups and downs approximately cancel out

 For

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Persistence of Technical Analysis

analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices  Studies show the markets are efficient in the weak form  Literature based on technical techniques continues to appear but should be useless
 Technical
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Chaos Theory
theory refers to instances in which apparently random behavior is systematic or even deterministic  Econophysics refers to the application of physics principles in the analysis of stock market behavior
 Chaos

E.g., an investment strategy based on studies of turbulence in wind tunnels

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