Applied Financial Econometrics Goh Kim Leng

ESGC6328: TOPIC 2 – Efficient Market Hypothesis

References
Fama, E.F. 1970. Efficient capital markets: a review of theory and empirical work,
Journal of Finance, Vol. 25, pp. 383-417.

Kok, K.L. 2000. Malaysian stock market and the efficient market hypothesis. In
Investment Analysis in the Malaysian Securities Market, ed. M.I. Mansor and K.L. Kok,
pp. 61-87. Kuala Lumpur: Research Institute of Investment Analysts Malaysia.

http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
http://www.investopedia.com/articles/02/112502.asp
http://www.investopedia.com/articles/02/101502.asp
http://www.investopedia.com/university/concepts/concepts5.asp
http://www.investopedia.com/university/concepts/concepts6.asp
http://www.answers.com/main/ntquery;jsessionid=18nlec3ukj318?method=4&dsid=2191
&dekey=efficientmarkethypothesis&gwp=8&curtab=2191_1&sbid=lc05b&linktext=Effi
cient%20Market%20Hypothesis%20-%20EMH
http://www.quantlet.com/mdstat/scripts/sfe/html/sfenode48.html
(accessed: 28 Dec 05)

1.1 Efficient Market Hypothesis (EMH)

Efficient market hypothesis (EMH) is an idea partly developed in the 1960s by Eugene
Fama. It states that it is impossible to beat the market because prices already incorporate
and reflect all relevant information. According to the EMH, no investor has an advantage
in predicting a return on a stock price since no one has access to information not already
available to everyone else.
Stocks always trade at their fair value on stock exchanges, and thus it is impossible for
investors to either purchase undervalued stocks or sell stocks for inflated prices.

Under the efficient market hypothesis, any time you buy and sell securities, you're
engaging in a game of chance, not skill. If markets are efficient and current, it means that
prices always reflect all information, so there's no way you'll ever be able to buy a stock
at a bargain price. Thus, the crux of the EMH is that it should be impossible to
outperform the overall market through expert stock selection or market timing, and that
the only way an investor can possibly obtain higher returns is by purchasing riskier
investments.

All members of the class of such "expected return theories" can be described notationally
as follows:

E(pj,t+i|Φt) = [1 +E(Rj,t+i|Φt)]pjt, (1)

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where E is the expected value operator; pjt is the price of security j at time t;
Rj,t + i is the one-period percentage return; Φt is a general symbol for whatever set of
information is assumed to be "fully reflected" in the price at t; pj,t+i and Rj,t+i are random
variables at t. The conditional expectation notation of (1) implies that whatever expected
return model is assumed to apply, the information in Φt is fully utilized in determining
equilibrium expected returns. And this is the sense in which Φt is "fully reflected" in the
formation of the price pjt.

The information set Φt have a major empirical implication—they rule out the possibility
of trading systems based only on information in Φt that have expected profits or returns
in excess ofequilibrium expected profits or returns. Thus let

xj,t+i = pj,t+i — E(pj,t+i|Φt) (2)

Then

E(xj,t+i |Φt) = 0 (3)

which, by definition, says that the sequence {xjt} is a "fair game" with respect to the
information sequence {Φ}. In economic terms, xj,t+i is the excess market value of security j at
time t + 1: it is the difference between the observed price and the expected value of tbe price that
was projected at t on the basis of the information Φt.

Or, equivalently, let

zj.t+i = Rj.t+i – E(Rj,t+i|Φt), (4)

then, E(zj,t+i|Φt) = 0, (5)

so that the sequence {zjt} is also a "fair game" with respect to the information sequence
{Φ}. zj,t+i is the return at t + 1 in excess of the equilibrium expected return projected at t.

This is a highly controversial and often disputed theory. Supporters of this model believe
it is pointless to search for undervalued stocks or try to predict trends in the market
through fundamental analysis or technical analysis. This theory has been met with a lot of
opposition, especially from the technical analysts. Their argument against the efficient
market theory is that many investors base their expectations on past prices, past earnings,
track records and other indicators. Because stock prices are largely based on investor
expectation, many believe it only makes sense to believe that past prices influence future
prices.

The Effect of Efficiency: Non-Predictability

The nature of information does not have to be limited to financial news and research
alone; indeed information about political, economic and social events, combined with
how investors perceive such information, whether true or rumored, will be reflected in
the stock price. According to EMH, as prices respond only to information available in the

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market, and, because all market participants are privy to the same information, no one
will have the ability to out-profit anyone else.

In efficient markets, prices become not predictable but random, so no investment pattern
can be discerned. A planned approach to investment, therefore, cannot be successful.

This "random walk" of prices, commonly spoken about in the EMH school of thought,
results in the failure of any investment strategy that aims to beat the market consistently.
In fact, the EMH suggests that given the transaction costs involved in portfolio
management, it would be more profitable for an investor to put his or her money into an
index fund.

How Does a Market Become Efficient?

In order for a market to become efficient, investors must perceive that a market is
inefficient and possible to beat. Ironically, investment strategies intended to take
advantage of inefficiencies are actually the fuel that keeps a market efficient.

A market has to be large and liquid. Information has to be widely available in terms of
accessibility and cost, and released to investors at more or less the same time. Transaction
costs have to be cheaper than the expected profits of an investment strategy.
Investors must also have enough funds to take advantage of inefficiency until, according
to the EMH, it disappears again. Most importantly, an investor has to believe that she or
he can outperform the market.

Sufficient conditions for capital market efficiency. Consider a market in which

(i) there are no transactions costs in trading securities,
(ii) all available information is costlessly available to all market participants, and
(iii) all agree on the implications of current information for the current price and
distributions of future prices of each security.

In such a market, the current price of a security obviously "fully reflects" all available
information. But a frictionless market in which all information is freely available and
investors agree on its implications is, of course, not descriptive of markets met in practice.
Fortunately, these conditions are sufficient for market efficiency, but not necessary.

Degrees of Efficiency
Accepting the EMH in its purest form may be difficult; however, there are three
identified classifications of the EMH, which are aimed at reflecting the degree to which it
can be applied to markets.

(1) Weak efficiency - This type of EMH claims that all past prices of a stock are reflected
in today's stock price. Therefore, technical analysis cannot be used to predict and beat a
market.

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• No excess returns can be earned by using investment strategies based on historical

share prices or other financial data.
• Weak-form efficiency implies that Technical analysis will not be able to produce
excess returns.

To test for weak-form efficiency it is sufficient to use statistical investigations on time

series data of prices. In a weak-form efficient market current share prices are the best,
unbiased, estimate of the value of the security. The only factor that affects these prices is
the introduction of previously unknown news. News is generally assumed to occur
randomly, so share price changes must also therefore be random.

(2) Semi-strong efficiency -This form of EMH implies that all public information is
calculated into a stock's current share price.

• Share prices adjust instantaneously and in an unbiased fashion to publicly

available new information, so that no excess returns can be earned by trading on
that information.
• Semi-strong-form efficiency implies that Fundamental and technical analysis will
not be able to produce superior gains or excess returns.

To test for semi-strong-form efficiency, the adjustments to previously unknown news

must be of a reasonable size and must be instantaneous. To test for this, consistent
upward or downward adjustments after the initial change must be looked for. [e.g. using
event studies, determination of event date and calculation of abnormal returns (AR) and
cumulative AR(CAR)]. If there are any such adjustments it would suggest that investors
had interpreted the information in a biased fashion and hence in an inefficient way.

(3) Strong efficiency - This is the strongest version, which states that all information in a
market, whether public or private, is accounted for in a stock price. Not even insider
information could give an investor an advantage.

• Share prices reflect all information and no one can earn excess returns.
• To test for strong form efficiency, a market needs to exist where investors cannot
consistently earn excess returns over a long period of time. When the topic of
insider trading is introduced, where an investor trades on information that is not
yet publicly available, the idea of a strong-form efficient market seems impossible.
Studies on the US stock market have shown that people do trade on inside
information. It was also found though that others monitored the activity of those
with inside information and in turn followed, having the effect of reducing any
profits that could be made.
• Even though many fund managers have consistently beaten the market, this does
not necessarily invalidate strong-form efficiency. We need to find out how many
managers in fact do beat the market, how many match it, and how many
underperform it. The results imply that performance relative to the market is more
or less normally distributed, so that a certain percentage of managers can be

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expected to beat the market. Given that there are tens of thousand of fund
managers worldwide, then having a few dozen star performers is perfectly
consistent with statistical expectations.

Possible to beat the market?

In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be
reasonable to see markets as essentially a mixture of both, wherein daily decisions and
events cannot always be reflected immediately into a market. If all participants were to
believe that the market is efficient, no one would seek extraordinary profits, which is the
force that keeps the wheels of the market turning.

In the age of information technology (IT), however, markets all over the world are
gaining greater efficiency. IT allows for a more effective, faster means to disseminate
information, and electronic trading allows for prices to adjust more quickly to news
entering the market. However, while the pace at which we receive information and make
transactions quickens, IT also restricts the time it takes to verify the information used to
make a trade. Thus, IT may inadvertently result in less efficiency if the quality of the
information we use no longer allows us to make profit-generating decisions.

Behavioral Finance

This field of study argues that people are not nearly as rational as traditional finance
theory makes out. For investors curious about how emotions and biases drive share prices,
behavioral finance offers some interesting descriptions and explanations.

The idea that psychology drives stock market movements flies in the face of established
theories that advocate the notion that markets are efficient. Proponents of efficient
market hypothesis say that any new information relevant to a company's value is quickly
priced by the market through the process of arbitrage.

For anyone who's been through the internet bubble and the subsequent crash, the efficient
market theory is pretty hard to swallow. Behaviorists explain that, rather than being
anomalies, irrational behavior is commonplace.

We can ask ourselves if studies on behavioral finance will help investors beat the market.
After all, rational shortcomings ought to provide plenty of profitable opportunities for
wise investors. In practice, however, few if any value investors are deploying behavioral
principles to sort out which cheap stocks actually offer returns that can be taken to the
bank. The impact of behavioral finance research still remains greater in academia than in
practical money management.

The behavioralists have yet to come up with a coherent model that actually predicts the
future rather than merely explains, with the benefit of hindsight, what the market did in
the past. The big lesson is that theory doesn't tell people how to beat the market. Instead

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it tells us that psychology causes market prices and fundamental values to diverge for a
long time.

Behavioral finance offers no investment miracles, but perhaps it can help investors train
themselves how to be watchful of their out behavior and, in turn, avoid mistakes that will
make them poorer.

Anomalies: The Challenge to Efficiency

In the real world of investment, however, there are obvious arguments against the EMH.
There are portfolio managers that have better track records than others, and there are
investment houses with more renowned research analysis than others. So how can
performance be random when people are clearly profiting from and beating the market?

Counter arguments to the EMH state that consistent patterns are present. Here are some
examples of some of the predictable anomalies thrown in the face of the EMH: the
January effect is a pattern that shows higher returns tend to be earned in the first month of
the year; and "blue Monday on Wall Street" is a saying that discourages buying on Friday
afternoon and Monday morning because of the weekend effect, the tendency for prices to
be higher on the day before and after the weekend than during the rest of the week.

Studies in behavioral finance, which look into the effects of investor psychology on stock
prices, also reveal that there are some predictable patterns in the stock market. Investors
tend to buy undervalued stocks and sell overvalued stocks, and, in a market of many
participants, the result can be anything but efficient.

Paul Krugman, MIT economics professor, suggests that because of the mass mentality of
the trendy, short-term shareholder, investors pull in and out of the latest and hottest
stocks. This results in stock prices being distorted and the market being inefficient.
So prices no longer reflect all available information in the market. Prices are instead
being manipulated by profit seekers.

The EMH Response

The EMH does not dismiss the possibility of anomalies in the market that result in the
generation of superior profits. In fact, market efficiency does not require prices to be
equal to fair value all of the time. Prices may be over- or undervalued only in random
occurrences, so they eventually resort back to their mean value. As such, because the
deviations from a stock's fair price are in themselves random, investment strategies that
result in beating the market cannot be consistent phenomena.

Furthermore, the hypothesis argues that an investor who outperforms the market does so
not out of skill but out of luck. EMH followers say this is due to the laws of probability:
at any given time in a market with a large number of investors, there will simply be who
that outperform, those who underperform and those who maintain the average.

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1.2. Random Walk

The stochastic process Xt is a martingale if the following holds

E[Xt|xt-1, xt-2, …, xt-k] = xt-1

for every k>0. The martingale is a frequently used instrument in describing prices in
financial markets.

The stochastic process Zt is a “fair game” if the following holds:

E[Zt|zt-1, zt-2, …, zt-k] = 0

for every k>0. Sometimes a fair game is also called a martingale difference. If Xt is a
martingale, then Zt= Xt - Xt-1 is a fair game.

An example of a martingale is the random walk without a drift.

The stochastic process Xt follows a random walk, if it can be represented as

Xt = µ + Xt-1 + εt

with a constant µ and white noise εt. If µ is not zero, then the variable Zt = Xt - Xt-1
= µ + εt have a non-zero mean. We call it a random walk with a drift.

Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random
Walk Down Wall Street", a book that is now regarded as an investment classic. Random
walk is a stock market theory that states that the past movement or direction of the price
of a stock or overall market cannot be used to predict its future movement. Originally
examined by Maurice Kendall in 1953, the theory states that stock price fluctuations are
independent of each other and have the same probability distribution, but that over a
period of time, prices maintain an upward trend.

In short, random walk says that stocks take a random and unpredictable path. The chance
of a stock's future price going up is the same as it going down. A follower of random
walk believes it is impossible to outperform the market without assuming additional risk.

In the early treatments of the efficient markets model, the statement that the current price
of a security "fully reflects" available information was assumed to imply that successive
price changes (or more usually, successive one-period returns) are independent. In
addition, it was usually assumed that successive changes (or returns) are identically
distributed. Together the two hypotheses constitute the random walk model. Formally,
the model says

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f(Rj,t+i|Φt )= f(Rj,t+i) (6)

which is the usual statement that the conditional and marginal probability distributions of
an independent random variable are identical. In addition, the density function f must be
the same for all t. The random walk model of (6) says that the entire distribution is independent
of Φt. In short, the random walk specifies that successive price changes are independent and
identically distributed.

Most empirical works examine the following:

E(Rj,t+i|Φt ) = E(Rj,t+i) (7)

This says that the mean of the distribution of Rj,t+i is independent of the information
available at t, Φt. If the current price of a security "fully reflects" available information,
the implication is that successive price changes (or more usually, successive one-period
returns) are independent. The distribution of the process is not studied in (7).

1.3. Tests of Weak-Form EMH

Consider a price series p1, p2, …, pn. Define the natural log price changes as:

vt = ln pt - ln pt-1

The weak-form EMH of (7) is considered. This is equivalent to testing the random walk
hypothesis. The tests discussed below consider only the independence aspect of the
random walk process.