Chapter 8 Efficient Market Hypothesis

Is there a pattern in the evolution of stock prices??

Stock prices follow a random walk; i.e. at any time, it cannot be said whether the stock price
of a company will increase, decrease or remain unchanged. This random evolution of stock
prices is due to the random manner in which information affects a stock market. Investors
take into consideration information, so as reassess a stock’s prospects and accordingly adjust
their buying and/or selling. It is known that the market price of a stock is established through
the forces of demand and supply.

Efficient market hypothesis: If a market is efficient, this implies that at all instants, the
prices of securities reflect all available information. (Fama 1970)

1. Anticipated/unanticipated information
2 types of information are integrated in stock prices:
- Anticipated information
- Unanticipated information

1.1 Anticipated information

- Future events that can be forecasted with a certain degree of accuracy.
Forecast of a company’s earnings; the economic conditions prevail next year...
E.g. a company forecasts high profits for the coming year; this has a positive impact on the
company’s stock price.

As the information is being anticipated, it will start having a positive impact on the stock
price prior to the date that the figures of high profits are released. If the market is efficient,

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when the profit figures are released (event time), this information is completely assimilated
and the stock price stabilises at a higher level.
(Negative anticipated event would have resulted in a gradual decrease in stock price, up to the
event time; where the stock price stabilises at a lower level).
If the market had been inefficient, then the impact of this anticipated information would have
had an influence on stock price, past the event time.
Note: at the event time, when investors learn the new information, they adjust their demand
and supply of securities accordingly; hence there would also be an immediate adjustment in
the security’s price towards a new equilibrium (up/down).

1.2 Unanticipated information

- Future events which cannot be predicted.
E.g. A bank discovers a loss in its account due to fraudulent practices.

As the information is unanticipated, the impact of the negative information would be

integrated in the stock price at the event time. This should result in an immediate decrease in
stock price, which stabilizes at a lower level.
(Positive unanticipated information would have caused an immediate increase in stock price
and a stabilization of the stock price at a higher level, at the event time).

If the market had been inefficient, the unanticipated information would not have been
completely integrated in the stock price on the event date. The information would have
influenced the stock price, past the event date.

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 2. Assumptions
The following assumptions are made in an efficient market:
(i) All investors have free access to current information about the future of securities.
(ii) There are no transaction costs (e.g. costs incurred for searching new information
and analysing the information).
(iii) All investors are capable analysts and pay close attention to market prices and
adjust their holdings appropriately.

3. Consequences of Market Efficiency

The consequences of an efficient market/ integration of all info at all instants would be that:
(i) Future share prices CANNOT be predicted because of unanticipated information.
(ii) At any time t, Intrinsic/ theoretical value of stock = market price of stock;
Investors are in possession of information about future of securities (e.g. cash flows) and are
assumed to be skillful analysts; therefore they should be able to predict very good estimates of
true/intrinsic value. In an efficient market it is given that intrinsic value = market price.

Temporarily there could be differences between market price and intrinsic value of stocks due
to unanticipated information. These differences are quickly exploited by investors (selling
overvalued securities and buying undervalued securities) and enable the equality between
stock price and value to be reached. In an efficient market, investors can make gains only by
chance and they cannot make gains in a consistent manner.

4. Three forms of market efficiency (distinguished by the degree of information

reflected in stock prices):
Weak-form efficiency: the current security price integrates information about past security
prices. No investor can earn excess returns by developing trading rules based on historical

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price or return information. I.e. information in past prices or returns is not useful or relevant in
achieving excess return as it is already integrated in the security price.

Semi strong-form efficiency: the security price integrates all publicly available information.
E.g. of publicly available information are: annual reports of companies, financial
newspapers… No investor can earn excess returns by using publicly available information, as
this information is already integrated in the security price. (Consider unanticipated
information in the graphic; e.g. release of the news of fraudulent practices within a bank).

Strong-form efficiency: the security price integrates all information, both public and private.
E.g. security analysts usually collect and analyse unpublished (insider/private) information on
companies.
No investor can earn excess returns; using private, public and past information.

If a market is strong-form, it would also be semi-strong form and weak form. A market which
is semi-strong form efficient is also weak-form efficient.

Note: it can happen that an individual, who has analysed past information or public/private
information, makes good prediction of future security price and generates a gain. In an
efficient market, this is considered as being a mere question of luck and this individual should
not be able to generate gains in a consistent manner by studying past/private/public
information.

5. Testing three forms of market efficiency:

- Weak-form efficiency: use statistical tests to show that there is no relation
between daily stock prices; i.e. today’s stock price is independent of yesterday’s
stock price (Correlation coefficient = 0). This confirms that in an efficient market,
future stock prices cannot be predicted.
- Semi strong-form efficiency: researches have measured the impact of public news
(e.g. dividend or earnings announcement, takeover announcement...) on stock
prices. (event studies)
E.g. a company X has announced that it wants to acquire another company Y
(public information); this announcement should have an immediate impact on

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 stock prices. If the market is efficient, on the announcement date, there should be
an immediate upward adjustment in the stock price of company Y.
Technical analysts use information on past prices of securities, to predict future
prices of securities.

- Strong-form efficiency: study the performance/records of professional investors,

e.g. security analysts, to see whether they are able to make gains in a consistent
manner. (This would imply that the investors are always able to predict the market
prices and intrinsic value correctly and hence determine securities which are
undervalued/overvalued).
At times investors are able to make gains, but according to efficient market
hypothesis, they generate gain by chance. (Gain made today does not imply a gain
would be made in the future). If market is efficient, investors cannot use public and
private information to forecast future security prices.