Chapter-6:Efficient Capital Markets

 Efficient Capital Market

 Efficient Market Hypothesis (EMH)
 Implication of Efficient Market Hypothesis (EMH)
 Condition of Efficient Capital Market
 Reasons for Expecting Capital Market to be Efficient
 Foundations of Market Efficiency
 Types of Efficient Market
 Evidence on Market Efficiency

Efficient Capital Market:



An efficient capital market is one in which the prices of all securities quickly and fully reflect all
available relevant information about the securities. The efficient markets have symmetric
information which means there is no gap in information flow among the investors in the market.
Efficient Market Hypothesis (EMH):


Efficient Market Hypothesis (EMH) states that a market is efficient if security prices
immediately and fully reflect all available relevant information. Efficient means
informational efficiency, not operationally efficient. Operational efficiency deals with the
cost of transferring funds. If the market fully reflects information, the knowledge that
information would not allow anyone to profit from it because stock prices already
incorporate the information.
Implication of Efficient Market Hypothesis (EMH):


The efficient market hypothesis (EMH) has implications for investors and for firms:
1. In an efficient market information is reflected in prices immediately, investors should
only expect to obtain a normal rate of return. Because they take time to realize the
news and thus fails to earn any abnormal return. So awareness of information when it
is released does an investor no good. The price adjusts before the investor has time to
trade on it.
2. Firms should expect to receive fair value for securities that they sell. Fair means that
the price they receive from issuing securities is the present value. Thus, valuable
financing opportunities that arise from fooling investors are unavailable in efficient
capital markets.
Condition of Efficient Market:


The conditions of an efficient capital market are as follows:

1. A large number of rational profit maximizing investors exist who actively participate in the
market by analyzing, valuing and trading stocks. These investors are price takers, that one
participant alone cannot affect the price of a security.
2. Information is cost less and widely available to market participant at approximately the same
time.
3. Information is generated in a random fashion such that announcements are basically
independent of one another.
4. Investors react quickly and fully to the new information, causing stocks prices to adjust
accordingly.

Reasons for Expecting Capital Market to be Efficient:



There are several reasons why one would expect capital markets to be efficient as
follows:
1. The foremost being that there are a large number of independent, profit-maximizing
investors engaged in the analysis and valuation of securities.
2. A second assumption is that new information comes to the market in a random
fashion.
3. The third assumption is that the numerous profitmaximizing investors will adjust
security prices rapidly to reflect this new information. Thus, price changes would be
independent and random.
4. Finally, because stock prices reflect all information, one would expect prevailing
prices to reflect “true” current value.

Foundations of Market Efficiency:



There are three pillars, any one of which will lead to efficiency:
1. Rationality
2. Independent deviations from rationality, and
3. Arbitrage.
1. Rationality:
In an efficient market all investors should be rational. When new information is released
in the marketplace, all investors will adjust their estimates of stock prices in a rational
way.
Example: Suppose, at present FCC’s stock price is Tk.40 per share. Now investors will
use the information in FCC’s press release, in conjunction with existing information
about the firm, to determine the NPV of FCC’s new venture. If the information in the
press release implies that the NPV of the venture is Tk.10 million and there are 2 million
shares, investors will calculate the NPV equal tk.5 per share ( 10 million ÷ 2 million =
Tk.5)
Now, the price of FCC’s stock is Tk.(40+5) = tk.45 per share.
As a rational investor,
Seller: A seller would sell the share of FCC only at a price of at least Tk.45, not less than
Tk.45
Buyer: A buyer would now be willing to pay up to Tk.45 for FCC’s share not more than
Tk.45.
2. Independent deviations from rationality:
Suppose that FCC’s press release is not all that clear. How many new cameras are likely
to be sold? At what price? What is the likely cost per camera? Will other camera
companies be able to develop competing products? How long will this likely take? If
these and other questions cannot be answered easily, it will be difficult to estimate NPV
With so many unanswered questions, many investors may not be thinking clearly. Some
investors predict that the product will have huge demand as it is a new product and
believing in sales projections well above than rational. Thus they would overpay for new
shares. And if they needed to sell shares, they would sell it only at a high price.
If these individuals dominate the market, the stock price would likely rise beyond what
market efficiency would predict. On the other hand, some investors react to new
information in a pessimistic manner. Thus they would prefer to pay less than rational
level for the new share.
We see that an efficient market consists of not only rational investors but also irrational
investors having optimistic and pessimistic attitudes.

A market becomes efficient still having irrational investors by offsetting their

undervalued and overvalued attitude towards the price of the stock and then making it at
rational price level.

Optimistic Price = Tk. 50 (Higher than rational; 50>45)

Pessimistic Price = Tk. 40 (Lower than rational; 40<45)

Rational price of an efficient market = (Optimistic Price + Pessimistic Price)/2 = Tk.(50+

40) / 2 = Tk.45 per share

3. Arbitrage:
A world with two types of individuals:
a) The irrational amateurs and
b) The rational professionals.
The amateurs get caught up in their emotions, sometimes believing irrationally that a
stock is undervalued and at other times believing the stock is overvalued. Because they
are not clear about the information. Thus, they would tend to carry stocks either above or
below their efficient prices.
But in the case of professional individuals, they go about their business methodically and
rationally. They study companies thoroughly, they evaluate the evidence objectively, they
estimate stock prices coldly and clearly, and they act accordingly. If a stock is
underpriced, they would buy it. If it is overpriced, they would sell it. And their
confidence would likely be greater than that of the irrational amateurs. Rational
professionals would be willing to rearrange their entire portfolio in search of a profit
through arbitraging where they generates profit from the simultaneous purchase and sale
of different, but substitute, securities. If the arbitrage of professionals dominates the
speculation of amateurs, markets would still be efficient.
Types of Efficient Market:


The notion that stock prices already reflect all available information is referred to as the
efficient market hypothesis (EMH). It is common to distinguish among three versions of
the EMH: (1) the weak, (2) semi-strong, and (3) strong forms. These versions differ by
their treatment of what is meant by “all available information.”
1. The Weak-form of Efficient Market:
The weak-form hypothesis asserts that stock prices already reflect all information that can
be derived from studying past market trading data including the historical sequence of
prices, price changes, and any volume information. It does not use any other information,
such as earnings, forecasts, merger announcements, or money supply figures. A capital
market is said to be weakly efficient, or to satisfy weak form efficiency, if it fully
incorporates the information in past stock prices. The implication is that there should be
no relationship between past price changes and future price changes. Therefore, any
trading rule that uses past market data alone should be of little value.

Weak form efficiency is represented mathematically as:

Price today (Pt) = P t-1 + Expected Return + Random error
Where, P t-1= sum of the last observed price, Expected Return is a function of a security’s
systematic risk and the random component is due to new information about the stock that
could be either positive or negative and has an expectation of zero.
Advantage:
Past stock prices are publicly available and virtually costless to obtain to take investment
decision in very easiest way.
Disadvantage:
It is not possible for the investors to decide whether the stock price is undervalued or
overvalued by simply observing the stock price movement based on historical price data.
Thus fails to generate extraordinary profits
 Stock Price Sell

Sell
Price
Price Movement Sell
Buy

0 Buy Time

2. The Semi-strong-form of Efficient Market:

The semi-strong form hypothesis states that all publicly available information about the
prospects of a firm must be reflected already in the stock’s price. Such information
includes, in addition to past prices, all fundamental data on the firm, its product, its
management, its finances, its earnings, etc., that can be found in public information
sources such as published accounting statements for the firm.
Advantage:
Semi-strong form efficiency requires not only that the market be efficient with respect to
historical price information, but that all of the information available to the public be
reflected in prices. Thus investors able to judge their investment decision in an accurate
manner than weak form of efficient market.
Disadvantage:
If the financial statements are not prepared in accordance with the GAAP, then there is a
possibility of misstatement which makes the investors unable to take proper investment
decision.
3. The Strong-form of Efficient Market:
The strong-form hypothesis states that stock prices reflect all information relevant to the
firm, even including information available to company “insiders.” This version is an
extreme one. Obviously, some “insiders” do have access to pertinent information long
enough for them to profit from trading on that information before the public obtains it.
Indeed, such trading - not only the “insiders” themselves, but also relatives and/or
associates - is illegal under rules of SEC. Thus we can say the market to be strong form
of efficient if stock prices reflect all information including public, private and historical.
Advantage:
All information is available in the market. So investors can easily take their investment
decision by analyzing all available information. There is no possibility of getting
abnormal return by hiding any information related to the firm.

AAAA
Strong Form
All information relevant to the stock

Information set of publicly available

Semi- Strong Form
information

Information set of past prices

Weak Form

Figure: Different types of efficient markets

Evidence on Market Efficiency:



Evidence is the base through which we can measure different types of efficient market.

1. Weak- form efficient market:

We can measure weak- form efficient market through correlation coefficient that
measures the relationship (degree and direction) between two variables. In weak- form
efficient market, serial correlation has been used which involves only one security. This
is the correlation between the current return on a security and the return on the same
security over a later period.
Serial correlation can be two types:
Positive coefficient of serial correlation: A positive coefficient of serial correlation for a
particular stock indicates a higher-than-average return today is likely to be followed by
higher-than-average returns in the future. Similarly, a lower-than-average return today is
likely to be followed by lower-than average returns in the future.
Negative coefficient of serial correlation: A negative coefficient of serial correlation for a
particular stock indicates a higher-than-average return today is likely to be followed by
lower-than-average returns in the future. Similarly, a lower-than-average return today is
likely to be followed by higher-than-average returns in the future.
Both positive and negative serial correlation coefficients are indications of market
inefficiencies. Because in either case, returns today can be used to predict future returns.
Serial correlation coefficients for stock returns near zero would be consistent with weak
form efficiency. Because return of today cannot be used to predict future returns.

2. The Semi-strong Form

The semi-strong form of the efficient market hypothesis implies that prices should reflect
all publicly available information. We present two types of tests of this form.
a) Event Studies:
A statistical study that examines how the release of information affect price of a stock at
a particulate time. It focuses on abnormal return (AR).
The abnormal return (AR) on a given stock for a particular day can be calculated by:
Abnormal return (AR) = Actual Return of Security – Expected Return of Security
Any past event does not affect the current return of stock. Only the present event or
announcement will affect the stock’s return. Announcements of dividends, earnings,
mergers, capital expenditures, and new issues of stock are a few examples that affect the
stock’s return.
b) The record of Mutual Funds:
Mutual funds pool funds from various investors and create portfolio of stocks by
analyzing different publicly available information. Actively managed mutual funds try to
use publicly available information and certain analytical skills to perform better than the
market as a whole. We consider the mutual fund is to be efficient which performance is
consistent with the market index.
3. The Strong Form:
Insiders who work within the firms have access to information that is not generally
available to public. The strong form of the efficient market hypothesis holds that, insiders
should not be able to earn profit by trading on their information. A government agency,
the Securities and Exchange Commission, requires insiders in companies to reveal any
trading they might do in their own company’s stock. By examining records of such
trades, we can see whether they made any abnormal returns or not. If the studies support
the view that these trades were abnormally profitable, then the market cannot be said as
strong form efficient.

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