493889265.

docx

1 Rational Expectations Theory

Describe the history of the analysis of investment markets giving rise to the efficient
markets hypothesis (EMH).

From the 1930s until the early 1960s, there was a widespread folklore about how to make
money on the stock market. The dominant theory, going back to Adam Smith in the 1700s,
was that markets are essentially fickle, and that prices tend to oscillate around some true or
fundamental value.

Starting with the seminal work by Benjamin Graham, traditional investment analysis involved
detailed scrutiny of company accounts, to calculate fundamental values, and thus ascertain
when a given investment is cheap or expensive. The objective would be to buy cheap stocks
and sell expensive ones. Any excess performance thus obtained would be at the expense of
irrational traders, who bought and sold on emotional grounds (a ‘gut feeling’, for example)
and without the benefit of detailed analysis.

By the 1960s, it had become clear that these supposedly foolproof methods of investment
were not working. Strategies based on detailed analysis did not seem to perform any better
than simple buy-and-hold strategies. Attempts to explain this phenomenon gave rise to the
Efficient Markets Hypothesis (EMH), which claims that market prices already incorporate the
relevant information. The market price mechanism is such that the active trading patterns of
a small number of informed analysts can lead to accurate market prices. Uninformed (or
‘cost-conscious’, since actively trading incurs potentially unnecessary costs) investors can
then take a free ride, in the knowledge that the research of others is keeping the market
efficient.

Discuss the three forms of the Efficient Markets Hypothesis and their consequences
for investment management.

In an efficient security market, the price of every security fully reflects all available and
relevant information. The efficient markets hypothesis states that security markets are
efficient.

1. Weak-form hypothesis: stock prices reflect all information that can be derived from
studying past market trading data. If markets are weak form efficient, then technical
analysis cannot be used to generate excess risk-adjusted returns.
2. Semi strong: stock prices reflect all publicly available information about the stock. If
markets are semi-strong form efficient, then fundamental analysis cannot be used to
generate excess risk-adjusted returns.
3. Strong form: stock prices reflect all information relevant to the firm, even including
information available only to company “insiders”. If markets are strong form efficient, then
insider trading cannot be used to generate excess risk-adjusted returns.

In the strong form of efficient market, a rule pertaining to company employees and
management over ban in stock trading eliminates benefit from insider trading. Explain
why such rules would be unnecessary.

The strong form of EMH suggests that the market prices incorporate all information, both
publicly available and also that is available only to insiders.

Page 1 of 10
 493889265.docx

If this exists, then even with insider information, the investors won’t be able to generate
higher returns. Hence, any such rules pertaining to company employees and management
over ban in stock trading would be unnecessary in a strong form of market.

What is the relationship between the three forms of market efficiency?

Publicly available information is a subset of all information, whether publicly available or not.
Consequently, strong form efficiency implies semi-strong form efficiency, in the sense that if
a market is strong form efficient, then it must also be semi-strong form efficient.

Similarly, as historical price data is a subset of all publicly available information, so a market
that is semi-strong form efficient must also be weak form efficient.

Why can active management not be justified according to the EMH?

According to the Efficient Markets Hypothesis, active investment management cannot be

justified because it is impossible to exploit the mispricing of securities to generate higher
expected returns. Even if price anomalies exist, then the costs of identifying them and then
trading will outweigh the benefits arising from the additional investment returns.

Explain the difference between an efficient market and an arbitrage-free market.

Efficient markets hypothesis claims that market prices already incorporate the relevant
information. The market price mechanism is such that the trading pattern of a small number
of informed analysts can have a large impact on the market price. Lazy (or cost conscious)
investors can then take a free ride, in the knowledge that the research of others is keeping
the market efficient.

If we assume that there are no arbitrage opportunities in a market, then it follows that any
two securities or combinations of securities that give exactly the same payments must have
the same price. This is sometimes called the “Law of One Price”.

Arbitrage-free markets can be inefficient as not having an arbitrage opportunity does not
mean that all the information is reflected in the market price of securities.

Which of the following phenomena would be either consistent with or violation of the
efficient market hypothesis? Explain briefly.

a) Nearly half of all professionally managed mutual funds are able to outperform the
BSE Sensex in a typical year.
b) Fund managers that outperform the market (on a risk adjusted basis) in one year
are likely to outperform in the following year.
c) Stock prices tend to be predictably more volatile in April than in other months.
d) Stock prices of companies that announce increased earnings in April tend to
outperform the market in May.

e) Stock that performs well in one month poorly performs in the following month.

a) Consistent. Based on pure luck, half of all managers should beat the market in any year.
b) Inconsistent. This would be the basis of an “easy money” rule: simply invest with last
year's best managers.

Page 2 of 10
 493889265.docx

c) Consistent. In contrast to predictable returns, predictable volatility does not convey a

means to earn abnormal returns.
d) Inconsistent. The abnormal performance ought to occur in January when earnings are
announced.
e) Inconsistent. Reversals offer a means to earn easy money: just buy last week’s losers.

For each statement, state the form of Market hypothesis that the Market exhibits, if the
following statements are correct. Explain briefly the reason:

a) Actively managed Mutual funds can consistently give higher returns than Nifty
Index returns due to their expertise in analysing companies’ earnings, Balance
sheet, etc.
b) A stock trader has made super normal profit for past 20 years using Bollinger-
band technique (a well- known technical tool)
c) A trust-worthy newspaper reports that XYZ Mining Corp has larger than expected
coal reserve which would increase the Market capitalization by 5% and the share
price increased by 5%.

d) A Television reporter traded in a stock and made money on the basis of

information in his ‘Interview’ with the management (before it was broadcast).

a) The market is either Weak form or inefficient. Under Semi-strong & Strong market, it’s
difficult to outperform the market using fundamental analysis in the long run.
b) The market is not even Weak form (hence, Inefficient) as technical analysis has given
super normal profits.
c) The market is Semi-strong as it has immediately reacted to the information coming to
public.
d) The market is not strong form and can be any of the other form as the reporter was able
to make money on the basis of insider information.

Describe the form of below mentioned activities according to Efficient Market

Hypothesis (EMH) in an idealistic world.

Stock prices traded in a regulated Semi-strong

stock exchange

Merger activities Strong

Lottery system Weak

The price of shares of a particular Strong form – The market price is incorporating the
company increase due to press publicly available information of increase in profits.
release by that company of
unexpected gains.

Usual correct tips from your friend for Semi strong form – Either insider information or
buy / sell of shares. fundamental analysis leads to high returns.

Active fund manager showing a lower Strong form – The fundamental or technical analysis
return than passive fund manager doesn’t lead to a better return.
over a long period.

“One can consistently outperform the This is inconsistent with the semi strong form of the

Page 3 of 10
 493889265.docx

market by adopting the contrarian EMH. If the semi strong form of EMH holds the low
approach as low P/E stocks tend to P/E should have an immediate effect on the share
have positive abnormal returns”. prices as the market should quickly and accurately
respond to the information.

“Post a merger announcement, share The prices are reacting when information is made
prices fall immediately” public. This suggests that the prices have previously
been distorted by insider information. Therefore, this
observation contradicts the strong form of EMH.

Market over reacts to the news and Contradicts all forms of efficiency because as per
corrects itself over couple of trading the EMH it is expected that the information is
sessions. reflected in the stock price immediately. Over
reaction or steady correction cannot happen in
efficient markets.

An investor earns returns that are
significantly higher than those
predicted by a log-normal model
fitted for a particular index using
technical analysis.
There are two possibilities here: Either the log
normal model is not applicable to the index in
question in which case nothing can be commented
on market efficiency OR the markets may be
inefficient if the modelling is correct as it is not
possible to consistently earn excess over the risk
adjusted returns.

Equity yields are correlated with the
yields implied in the last three trading
sessions and show an element of
mean revision over a 4-5-year
timeframe.
When data for 3 sessions is considered, it
contradicts weak form of market efficiency. As per
the weak form knowledge of price history should not
be of any use if last price is known. However, the
auto-correlation does add information about the
behaviour of share price. The mean revision can
also be due to change in investors’ risk return
preferences and no comments can be made for the
4-5-year period.

Can technical analysis be applied in The semi strong form of market is said to be in
semi strong form of efficient market? existence if the market prices incorporate all publicly
available information.

The technical analysis relies on making trading rules

based on historical price data to generate higher
investment returns. Since in semi strong form of
market, the prices already incorporate all public
information, technical analysis won’t help investors
generating any additional returns.

In semi strong form of efficiency,
information level differs for different
group of investors or institutions.
In semi strong form of market, prices already
incorporate all publicly available information.
However, the extent of public information might vary
from investor to investor. For instance, different
stock exchanges having different disclosure

Page 4 of 10
 493889265.docx

requirements are expected to have different levels of

public information and hence, efficiency.

In addition, there could be additional costs involved

in obtaining the public information accurately and
quickly which otherwise would dilute the market
efficiency.

A particular portfolio comprising The portfolio may outperform because it is a higher

equity of high growth companies
outperforms the market. Does this
indicate that the Efficient Market
Hypothesis (EMH) is contradicted?
risk portfolio than the market. This does not
contradict the EMH. The market rewards investors
for taking higher risk and it is expected that on an
average, a higher risk portfolio will result in higher
return.

Semi-strong form of EMH suggests
that an investor can’t beat the market
in long term. Suggest some reasons
if a particular investor outperforms
the market systematically over long
period.
By taking higher systematic risk i.e. by buying stocks
with higher beta
If the investor trades on the basis of inside
information.

2 The evidence for or against each form of the Efficient Markets Hypothesis

State difficulties faced when testing the EMH.

• Although, it may be possible to exploit temporary mis-pricings, it may not be possible in

practice after appropriate allowance has been made for both transaction costs and the
cost of obtaining information. Whether or not such a finding contradicts EMH depends on
exactly how we define EMH.
• There is no universally agreed definition of risk, and no perfectly accurate way of
measuring it. Hence it is difficult to conclude if out-performance of an investment strategy
was purely compensatory for risk taken or not.
• Testing requires making implicit / explicit assumptions which are open to criticism. For
example, choice of discount rate, normality or returns, stationary of time series,
estimates of variance and covariance etc.
• It is difficult to define publicly available information.
• It is difficult to determine when, precisely, information arrives.
• EMH does not specify how information is priced. So, very difficult to test.
• Even if the market is efficient, pure chance is going to throw up some apparent examples
of mis-pricings.
• Testing of strong form efficiency is problematic ass it requires the researchers to have
access to information that is not in the public domain.
• The assumptions made about how security prices should react to new information may
be invalid.

Explain what is meant by informational efficiency. What are the major difficulties
involved with testing for informational efficiency? What is the empirical evidence
concerning informational efficiency?

Page 5 of 10
 493889265.docx

In informational efficiency: The market for a particular security is said to exhibit informational
efficiency if new information is incorporated quickly and accurately into the price of the
security.

The major difficulties are:

 It can be difficult to decide exactly what constitutes publicly available information when
testing the semi-strong form.
 It is empirically difficult to determine exactly when a particular piece of information
becomes available. When does the information become available to anyone (strong form
efficiency) or publicly available (semi-strong form efficiency)?
 In order to test for strong form efficiency, you need access to information that is not
publicly available.
 It is difficult to judge exactly the extent to which the market price should react to a
particular event and hence to determine whether it has in fact under or over reacted to
that event. (This applies to all three forms.)

Empirical evidence concerning informational efficiency:

Many studies show that the market over-reacts to certain events and under-reacts to other
events.

Over reaction to events:

 Past winners tend to be future losers and the market appears to over-react to past
performance.
 Certain accounting ratios appear to have predictive powers, an example of the market
apparently over-reacting to past growth.
 Firms coming to the market have poor subsequent performance.

Under-reaction to events:

 Stock prices continue to respond to earnings announcements up to a year after their

announcement.
 Abnormal excess returns for both the parent and subsidiary firms following a demerger.
 Abnormal negative returns following mergers.

Describe the evidence for and against all the three forms of Efficient Market
Hypothesis covering detailed aspects related to informational asymmetry.

Difficulty in testing EMH – There is a substantial body of literature proving the existence of
mis-pricings, in contravention of EMH. There is also a substantial body of literature proving
various forms of EMH.

Testing the strong form EMH:

This is problematic, as it requires the researcher to have access to information that is not in
the public domain. However, studies of directors’ share dealings suggest that, even with
inside information, it is difficult to out-perform.

Testing the weak form EMH:

Page 6 of 10
 493889265.docx

Using price history to try and forecast future prices, often using charts of historical data, is
called technical or chartist analysis. Studies have failed to identify a difference between the
returns on stocks using technical analysis and those from purely random stock selection
after allowing for transaction costs. No credible challenge has emerged to the EMH in its
weak form.

Testing the semi-strong form EMH:

The semi-strong form of the EMH has been where research has concentrated and in
particular focused on tests of informational efficiency and volatility tests. We will consider
tests of this form of EMH in two categories, tests of informational efficiency and volatility
tests:

Informational Asymmetry:

Many studies show that the market over-reacts to certain events and under-reacts to other
events. The over/under-reaction is corrected over a long time period. If this is true then
traders could take advantage of the slow correction of the market, and efficiency would not
hold.

Over reaction

i. past winners tend to be future losers and vice versa. Market tends to over-react to
past performance.
ii. stocks coming to the market by Initial Public Offerings and Seasoned Equity
Offerings have poor subsequent long-term performance
iii. Certain accounting ratios appear to have predictive powers, e.g. companies with high
earnings to price, cashflow to price and book value to market value, i.e. generally
poor past-performers, tend to have higher future returns. Again, an example of
markets apparently overreacting to past performance.

Under reaction

 Stock prices continue to respond to earnings announcements up to a year after their

announcement. This is an under-reaction that corrects itself slowly.
 Abnormal excess returns for both the parent and subsidiary firms following a de-
merger. Another example of market being slow to recognise the benefits of an event.
 Abnormal negative returns following mergers

Anomalies

i. Anomalies attributed to behavioural patterns

ii. Ability of accounting ratios to indicate out-performance, are arguably proxies for risk.
Once these risks have been taken into account, many studies which claim to show
evidence of inefficiency turn out to be compatible with the EMH.

Volatility Tests:

Shiller first formulated the claim of “excessive volatility” into a testable proposition in 1981.
He found strong evidence that the observed level of volatility contradicted the EMH.
However, subsequent studies using different formulations of the problem found that the
violation of the EMH only had borderline statistical significance.

Page 7 of 10
 493889265.docx

What are volatility tests? Why are the historical volatility tests described as
inconclusive? Outline the claim of excessive volatility in stock markets made by
Shiller, along with four criticisms made of the test.

A lot of tests have been done to observe that the change in market value of stocks
(observed volatility) cannot be justified by the news arriving.

These tests claimed to be evidence of market over-reaction which was not compatible with
efficiency.

The claim of 'excessive volatility' was first put into testable proposition by Shiller in 1981. He
used a discounted cash flow model based on the actual dividends that were paid and some
terminal value for the share to calculate a perfect foresight price for the equity. This would
represent the “correct” equity price if market participants had been able to predict future
dividends correctly.

The difference between the perfect foresight price and the actual price arises from the
forecast errors of future dividends. If market participants are rational, there should be no
systematic forecast errors. Also if markets are efficient, then broad movements in the perfect
foresight price should be correlated with moves in the actual price as both are reacting to the
same news and hence the same changes in the anticipated future cash flows.

Shiller found strong evidence that the observed level of volatility in the S&P 500 stock index
contradicted the EMH as such volatility was not in line with the subsequent fluctuations in the
dividends.

However, subsequent studies, using different formulations of the problem, found that the
violation of the EMH only had borderline statistical significance. Numerous criticisms were
subsequently made of Shiller’s methodology.

These criticisms covered:

 the choice of terminal value for the stock price

 the use of a constant discount rate
 bias in estimates of the variances because of autocorrelation
 possible non-stationarity of the series, i.e. the series may have stochastic trends that
invalidate the measurements obtained for the variance of the stock price.

Although subsequent studies by many authors have attempted to overcome the

shortcomings in Shiller’s original work, there still remains the problem that a model for
dividends and distributional assumptions are required. Some equilibrium models now exist
which calibrate both to observed price volatility and observed dividend behaviour. However,
the vast literature on volatility tests can at best be described as inconclusive.

What is meant by 'Excessive volatility’ under Efficient Market Hypothesis (EMH)?

The 'excessive volatility' arises when the security prices are more volatile than the underlying
fundamental variables that should be driving them and when the change in prices couldn't be
justified by the news arriving alone. This was claimed to be evidence of market over-reaction
which was not compatible with the efficient market hypothesis. Under EMH, all the

Page 8 of 10
 493889265.docx

information is expected to reflect fully under the security market prices and any deviations
are assumed to be the result of 'under' or 'over' reaction to events.

Why should the returns net of various costs be considered to test the efficiency of
markets?

It may be possible to forecast some market movements, but the research costs of making
the forecasts (or paying a fund manager to do it for you), plus the transaction costs
(brokerage, market impact) of executing the deal must be taken into account.

To demonstrate an exploitable opportunity, it must be shown that opportunity is large enough

to remain intact even after all these costs are taken into account.

The existence of fund managers who sell their services based on their alleged ability
to select over-performing sectors and stocks and so add value to portfolios
demonstrates that capital markets are not efficient. Discuss the above statement.

Some examples of valid points are:

• Some managers do appear to generate returns in excess of the market returns on a

regular basis.
• This outperformance is not consistent, in particular a manager cannot guarantee to
produce excess performance in any given year.
• Given the diversity of investment services we would expect by pure chance that some
managers would have above average track records over short/medium time periods.
• The outperformance is usually prior to charges being taken into consideration. Once
charges are included there is extremely limited evidence of consistent outperformance.
• The risk of positions must be taken into account. A higher risk portfolio should provide,
on average, higher returns to compensate for the risk. For sensible comparisons risk
adjusted returns are required.
• Fund managers are also employed to build and maintain diversified portfolios or
specialist portfolios with specific mandates (ethical or high risk). An efficient market does
not mean that tailored portfolios will not be required by some investors.
• Capital markets are closer to the idealised “perfect markets”. More likely that
inefficiencies arise in the market for buying and selling investment services rather than
the markets for buying/selling securities.

Outline the main points you would make in a discussion of the statement: The
efficient markets hypothesis states that the market price is always correct and
therefore it is not possible for investors to make money from investing in shares.

“The efficient markets hypothesis states that the market price is always correct”

 EMH states that prices react quickly and accurately to new information, which can be
treated as saying that the prices are correct in the sense that they factor in all the
available information.
 However, it is important to distinguish between the different types of information that are
factored into the prices. This could be just past price history (the weak form) or all
publicly available information (semi-strong) or all information, including privileged
information known only to company directors (strong form).

Page 9 of 10
 493889265.docx

 If the relevant form of EMH applies, it is not possible to make a risk-adjusted profit based
on that category of information. For example, if markets are weak-form efficient, then
technical analysts should not be able to benefit from their analysis.

“It is not possible for investors to make money from investing in shares”

 This does not mean that it is not possible to make money by investing in shares. In the
long-term shares are generally believed to offer a higher expected return than investing
in a risk-free asset. However, if the market is efficient, it should not be possible to
outperform other investors who are working from the same information and within the
same constraints.
 However, if additional information is available, higher returns may be possible e.g. if an
investor in a semi-strong form market has access to insider information (which may be
illegal to make use of), this could provide an advantage.
 It may also be possible to pay for more detailed analysis that provide additional
information not directly available to the public.
 It may also be possible to obtain information more quickly than other investors, which
would give an advantage.
 Also, if an investor is prepared to accept a higher level of risk, he or she can obtain
higher expected returns, even if the markets are efficient.
 There has been considerable research into testing whether the markets are indeed
efficient and at what level, but there are difficulties with such testing.
 The weak form can be tested by retrospectively comparing the performance of strategies
recommended by technical analysts with randomly selected portfolios. The problem here
is that there will be a wide range of possible strategies and some are bound to do well
purely by chance.
 The semi-strong form can be tested by looking for excessive volatility in price
movements, as was done by Shiller in his analysis in 1981. This involved retrospectively
comparing the actual price movements with the theoretical movements according to the
model he used. He found evidence of excessive volatility, which would refute the semi-
strong form of EMH. However, other economists have questioned his model and its
assumptions.
 The strong form can be tested by comparing the returns obtained by directors who have
access to privileged information. However, most markets do not allow insider trading and
prevent directors trading during certain times which is likely to remove this advantage.

Is the statement true or false? ‘The semi-strong form of the Efficient Markets
Hypothesis suggests that no investor will ‘beat’ the market in the long term.’

The laws of probability suggest that some investors will achieve returns in excess of the
market even over the long term purely by chance. For example, they might happen to be
holding a particular company’s shares when some ‘good’ news is announced. However, the
Efficient Markets Hypothesis suggests that no one will be able to do so systematically
unless:

 they accept a higher level of risk than exhibited by the market as a whole, or
 they have inside information.

Page 10 of 10