Security Analysis and

Portfolio Management
BITS Pilani Dr. Shreya Biswas
Hyderabad Campus Department of Economics and Finance
Learning objectives

• Concept of efficiency in financial markets

• Form of EMH

• Implications of EMH

• Testing EMH

Semester-I-2021-22 BITS Pilani, Hyderabad Campus

 Concept of Efficiency
Information is quickly disseminated and security prices adjust rapidly to
any new information.

Assumptions:
– All investors have costless access to currently available
information about the future
– All investors are capable analysts
– Investors pay attention to market prices and adjust their holdings
accordingly.

• In such a market security’s price will be a good indicator of its

investment value.

• Investment value is the security’s intrinsic or fair value.

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 Efficient Market Hypothesis

• Fama’s definition:
A market is efficient with respect to a particular set of information if it
is impossible to make abnormal profits (other than by chance) by
using this set of information to formulate buying and selling.

• Price changes as information arrives in the market.

• Information is unpredictable hence change in price should be

unpredictable – Random walk

• Competition as source of efficiency – People should get

remunerated for time and money devoted in tracking securities.

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• EMH implies allocational efficiency.

• Allocationally efficient market: Capital should be channeled to

entities that will use it most efficient manner/ to firms which
have most promising investment opportunities.

• Example: Firm1 is better performing than Firm 2 – stock price

of F1 is say Rs.100 and that of F2 is Rs50. To raise
Rs.1million F1 will need to issue 10000shares and F2 will
need to issue 20000shares – less costly for F1 to raise money

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 Weak form of EMH
• Weak form of EMH: It is impossible to make abnormal profits (other
than by chance) by using past prices and trading volumes to formulate
buying and selling decisions.

• Price follow a Random Walk – price movements are unpredictable

• Technical analysis -Search for patterns in stock prices and volumes.

• EMH implies that technical analysis cannot generate profits for

long horizons.

• Weak form of EMH suggests that information available in past prices

has already been incorporated in current prices.

• Analyst can uncover some information in stock price which no one else
knew for once

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 Semi-strong form of EMH
• Semi-strong form: It impossible make abnormal profits (other than by
chance) by using all publicly available information to formulate buying and
selling decisions.

• Fundamental analyst studies stock prices, firm’s earnings, firm’s standing in

the industry and economic conditions, prospects of the industry, firm’s
management etc., to determine fair price of the stock.

• EMH predicts that fundamentalists will not be able to generate abnormal

profits if they are relying on widely available information.

• If analyst has access to some rare information or does an analysis which is

better than the rivals, there can be profit opportunities.

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 Implications of EMH

• Stock picking at the individual level may not be fruitful. (Trade-off

between effort and slight higher returns)

• Small investors may opt for MFs over active portfolio management.

• Active fund management by portfolio managers may not be justified

given the level of expenses.

• Passive fund management – Well diversified portfolio without

focusing on stock picking – Index funds

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Implications of EMH

• Security selection is important for creating diversified portfolio

and reducing firm specific risk

• Tax considerations- Bonds versus equity, Tax-free vs taxable

bonds, Dividends vs capital gains

• Risk aversion- Age and wealth effects

• Occupational profile- CEO should not prefer stock of the same

company, older people may not prefer long term bonds or
young firms.

• Portfolio management is not inconsistent with EMH

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 Strong form of EMH

• Strong form: It is impossible to earn abnormal profits (other than by

chance) by using all publicly and privately available information to
formulate buying and selling decisions.

• Regulatory restrictions on insider trading

• When we refer to efficient markets, we mean/ desire semi-strong

and weak form.

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 Tests of weak EMH

Weak form of EMH: Testing the Random Walk Hypothesis

• Correlation tests:

• Short term-
• Correlation coefficient of price changes of one week with
the price changes a week later and so on down the line.

• Correlation tests on daily price changes Fama(1965) and

found low correlation

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Correlation test

• Statistical test: Null: Rho=0; Alternate: Rho≠0 (Price can

be forecasted)

• |Correlation|>1.96/ 𝑛 implies Random Hypothesis can be

rejected at 5% LOS

• Example for 400 data points, correlation >0.098 indicates

RW does not hold

• Long term correlation test – Using monthly or yearly data

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Runs test

• For daily data, a run is defined as a sequence of days in

which the stock price changes in the same direction.

• Consider the sequence :+++++----+-+--

• + sign means that the stock price increased, and a −

sign means that the stock price decreased

• In above example there are 6 runs in a span of 14days

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• Investing based on technical analysis rejects the
random-walk theory.

• The assumption is that trends continue: a price increase

implies further price increases, a price decrease implies
further price decreases.

• One buys when the stock price is rising and sells when it
is falling

• For n observations expected number of runs as per RW

hypothesis is n/2

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Statistic for Runs test

Test statistic for Runs test:

2𝑛1 𝑛2
𝐸 𝑅𝑢𝑛𝑠 = +1
𝑛
2𝑛1 𝑛2 (2𝑛1 𝑛2 − 𝑛)
𝑉𝑎𝑟 𝑅𝑢𝑛𝑠 =
𝑛2 (𝑛 − 1)
𝑅𝑢𝑛𝑠 − 𝐸(𝑅𝑢𝑛𝑠)
𝑧=
𝑆𝑡𝑑 𝐷𝑒𝑣(𝑅𝑢𝑛𝑠)

Reject RW if |z|>1.96 and conclude that prices can be predicted

https://www.itl.nist.gov/div898/handbook/eda/section3/eda35d.ht
m

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 Tests for Semi-strong EMH

• Event study methodology – Using the market model predict

abnormal returns around an event

• Consider an important event like merger announcement,

earnings announcement, demonetization announcement,
current lockdown etc.

• Define the day of announcement as day zero (“0”)

• Calculate daily returns for the security for a period -100 to -5/-
3 (estimation window)

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Event study contd.

• Estimate the single index model to obtain the intercept and

slope.

• Obtain abnormal return as: A𝑅𝑖𝑡 = 𝑅𝑖𝑡 − 𝐸(𝑅𝑖𝑡 )

• Perform a t-test to test whether the mean of AR is zero or not.

• |t|>1.96 indicates that the abnormal return on average is non-

zero and semi-strong form of efficiency may not hold

• Define cumulative abnormal returns as : CA𝑅𝑖 = σ3𝑡=−3 𝐴𝑅𝑖𝑡

• Event window may vary from -3/+3 to -20/+20

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 Thank you

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