ECF350/BAS430

The Efficient Market Hypothesis (EMH)

o Introduction to Efficient Markets Hypothesis
o Forms of efficient market hypothesis
o Consequences of EMH forms for investment
management.
o Evidence for or against each form of the Efficient
Markets Hypothesis.
Readings: (1) Brealey et al (2014) Chapter 13
(2) Ross et al (2016) Chapter 14
 An efficient market refers to the degree to which market
prices reflect all available and relevant information
 If markets are efficient, then all information is already
incorporated into prices, and so there is no way to "beat"
the market because there are no undervalued or
overvalued securities available
 The efficient-market hypothesis is a hypothesis in
financial economics that states that asset prices reflect
all available information
 A direct implication is that it is impossible to "beat the
market" consistently on a risk-adjusted basis since
market prices should only react to new information
 The concept of efficient capital markets stemmed
from a chance discovery
 Ideas started with Maurice Kendall, a British
statistician, in 1953 (behaviour of stock and
commodity prices)
 He found that the prices of stocks and commodities
seemed to follow a random walk.
 Note: A random walk has no specific pattern and this
was against Kendall‟s expectations
 You are given ZMW100 to play a game. At the end
of each week a coin is tossed. If it comes up head,
you win 3% of your investment; if it is tail, you lose
2.5%.
 Therefore, your capital at the end of the first
week is either ZMW103.00 or ZMW97.50.
 At the end of the second week the coin is tossed
again.
 Therefore, your capital at the end of the second
week are conditional on the outcome of the first
week
 If first week‟s outcome was Head, then
 Your capital at the end of the first week is either
ZMW106.09 or ZMW100.43.

 If first week‟s outcome was Tail, then

 Your capital at the end of the first week is either
ZMW100.43 or ZMW95.03.
 ZMW106.09
ZMW103.00
ZMW10.43
ZMW100.00
ZMW100.43
ZMW97.57
ZMW95.03
 This also means that

 𝑃𝑎𝑦𝑜𝑓𝑓 𝐻2 𝐻1 = 𝑍𝑀𝑊106.09

 𝑃𝑎𝑦𝑜𝑓𝑓 𝑇2 𝐻1 = 𝑍𝑀𝑊100.43

 𝑃𝑎𝑦𝑜𝑓𝑓 𝐻2 𝑇1 = 𝑍𝑀𝑊100.43

 𝑃𝑎𝑦𝑜𝑓𝑓 𝑇2 𝑇1 = 𝑍𝑀𝑊95.03

 These outcomes follow a random walk with a

positive drift of 0.25%.
 It is difficult to know whether the outcomes are
correlated unless you compute the correlation
coefficient
 The stock prices are highly volatile and thus have no
pre-determined outcome but will follow a random
walk process.
 What would happen in the market if prices were
predictable and that investors foresee a possible
50% increase in stock prices from ZMW4 to ZMW6?
 The market situation will self-destruct
 Since a stock is a bargain at ZMW5, and thus
investors will rush to buy the stock today before the
rise in price.
 They will stop buying only when the stock offers a
normal risk-adjusted rate of return – a rate that
measures the profit made relative to the risk
presented by the investment over a given period of
time
 Thus in a random walk model, all the information in
past prices will be reflected in today‟s stock price,
not tomorrow‟s
 There are three forms of efficient markets
Hypothesis
 The forms are distinguished by the degree of
information reflected in security prices

 Weak – Form EMH

 Semi – Strong Form EMH
 Strong – Form EMH
Weak – Form EMH
 This form predicts that prices reflect the information
contained in the record of past prices
 That is, today‟s prices is a reflection of the prices in
the past
𝑃𝑡 = 𝑓(𝑃𝑡−𝑗 ), for j = 1,2,3,…,n
 If markets are efficient in the weak sense, then it is
impossible to make consistently superior profits by
studying past returns
 Thus, Prices will follow a random walk
Weak – Form EMH
 This form predicts that prices reflect the information
contained in the record of past prices
 That is, today‟s prices is a reflection of the prices in
the past
𝑃𝑡 = 𝑓(𝑃𝑡−𝑗 ), for j = 1,2,3,…,n
 If markets are efficient in the weak sense, then it is
impossible to make consistently superior profits by
studying past returns
 Thus, Prices will follow a random walk
Semi – Strong – Form EMH
 This form requires that prices reflect not just past
prices but all other public information (e.g.,
information from the Internet or the financial press)
𝑃𝑡 = 𝑓(𝑃𝑡−𝑗 , 𝐼𝑡 ), for j = 1,2,3,…,n
 If markets are semi strong efficient, then prices will
adjust immediately to public information such as the
announcement of the last quarter‟s earnings, a new
issue of stock, or a proposal to merge two
companies
Semi – Strong – Form EMH
 It says that the market will quickly digest the
publication of relevant new information by moving
the price to a new equilibrium level that reflects the
change in supply and demand caused by the
emergence of that information
 However, one major problem lies with the
identification of „relevant publicly available
information‟
Strong – Form EMH
 This form requires that prices reflect all the
information that can be acquired by painstaking
analysis of the company and the economy
 In such a market we would observe lucky and
unlucky investors, but we wouldn‟t find any superior
investment managers who can consistently beat the
market
𝑃𝑡 = 𝑓(𝑃𝑡−𝑗 , 𝛾𝑡−𝑖 ), for j = 1,2,3,…,n and i = 0,1, … , 𝑛
Strong – Form EMH
 In its strongest form, the EMH says a market is efficient
if all information relevant to the value of a share,
whether or not generally available to existing or potential
investors, is quickly and accurately reflected in the
market price
 For example, if the current market price is lower than
the value justified by some piece of privately held
information, the holders of that information will exploit
the pricing anomaly by buying the shares
 They will continue doing so until this excess demand for
the shares has driven the price up to the level supported
by their private information.
Strong – Form EMH
 At this point they will have no incentive to continue
buying, so they will withdraw from the market and
the price will stabilise at this new equilibrium level
 The strong form of EMH is the most satisfying and
compelling form of EMH in a theoretical sense
 However, it is difficult to confirm empirically, as the
necessary research would be unlikely to win the
cooperation of the relevant section of the financial
community – insider dealers
 The Efficacy of Dart Throwing
 “. . . throwing darts at the financial page will
produce a portfolio that can be expected to do as
well as any managed by professional security
analysts.”
 This is almost, but not quite, true because all the
efficient market hypothesis really says is that, on
average, the manager cannot achieve an
abnormal or excess return
 The excess return is defined with respect to some
benchmark expected return, such as that from the
security market line
 The Efficacy of Dart Throwing
 The investor must still decide how risky a portfolio
she wants
 In addition, a random dart thrower might wind up
with all of the darts sticking into one or two high-
risk stocks that deal in genetic engineering
 Efficiency indicates that the price investors pay
when they buy a share of stock is a fair price in
the sense that it reflects the value of that stock
given the information that is available about it
 Price Fluctuations
 Much of the public is skeptical of efficiency
because stock prices fluctuate from day to day
 However, daily price movement is in no way
inconsistent with efficiency; a stock in an efficient
market adjusts to new information by changing
price
 A great deal of new information comes into the
stock market each day
 In fact, the absence of daily price movements in a
changing world might suggest an inefficiency
 Stockholder Disinterest
 Many laypeople are skeptical that the market
price can be efficient if only a fraction of the
outstanding shares changes hands on any given
day
 However, the number of traders in a stock on a
given day is generally far less than the number of
people following the stock and this is true
because an individual will trade only when his
appraisal of the value of the stock differs enough
from the market price to justify incurring
brokerage commissions and other transaction
costs
 Stockholder Disinterest
 Furthermore, even if the number of traders
following a stock is small relative to the number
of outstanding shareholders, the stock can be
expected to be efficiently priced as long as a
number of interested traders use the publicly
available information
 That is, the stock price can reflect the available
information even if many stockholders never
follow the stock and are not considering trading in
the near future.
 Weak Form EMH
 Weak form efficiency implies that a stock‟s past
price movement is unrelated to the stock‟s future
price movement
 Evidence can be presented using correlation
analysis
 Returns on two different stocks from related
industries are likely to be highly correlated than
those from unrelated industries
 Toyota and Mitsubishi (High correlation)
 Toyota and Zambeef (Low correlation)
 Weak Form EMH
 In Economics, we are concerned with serial
correlation involving one security
 Thus, we measure the correlation between the
current return on a security and the return on the
same security over a later period
 A positive coefficient of serial correlation for a
particular stock indicates a tendency toward
continuation
 A negative coefficient would indicate a reverse
 Weak Form EMH
 With a positive coefficient of serial correlation,
o a higher-than-average return today is likely to
be followed by higher-than-average returns in
the future
o a lower-than-average return today is likely to be
followed by lower-than-average returns in the
future.
 Significantly positive serial correlation coefficients
are indications of market inefficiencies – because
they can be used to predict the future
 Weak Form EMH
 With a Negative coefficient of serial correlation,
o a higher-than-average return today is likely to
be followed by lower-than-average returns in
the future
o a lower-than-average return today is likely to be
followed by higher-than-average returns in the
future.
 Significantly negative serial correlation coefficients
are indications of market inefficiencies – because
they can be used to predict the future
 Weak Form EMH
 With a coefficient of serial correlation near Zero,
o a higher than average return is as likely to be
followed by lower-than-average returns as by
higher-than-average returns.
o a current stock return that is lower than average is
as likely to be followed by higher-than average
returns as by lower-than-average returns.
 Serial correlation coefficients for stock returns near
zero would be consistent with weak form efficiency –
because they can be used to predict the future
 Weak Form EMH
 Other evidence from the works of both
psychologists and statisticians suggests that most
people simply do not know what randomness
looks like
 Weak Form EMH
 Semi Strong Form EMH
 The semi-strong form of the efficient market
hypothesis implies that prices should reflect all
publicly available information
 Here, evidence is on the event studies and the
records of mutual funds
 We consider abnormal return
 The abnormal return (AR) on a given stock for a
particular day can be calculated by subtracting
the market‟s return on the same day (𝑅𝑚 ) from
the actual return (R) on the stock for that day
 Semi Strong Form EMH
 Algebraically, to present the equation for
abnormal return (AR), we start from the adjusted
return
𝐴𝑑𝑗. 𝑅 = 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑖𝑛𝑑𝑒𝑥

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝛼 + 𝛽 × 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑖𝑛𝑑𝑒𝑥

𝐴𝑅 = 𝑎𝑐𝑡𝑢𝑎𝑙 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛

 Semi Strong Form EMH
 Secondly, if the market is efficient in the semi
strong form, then no matter what publicly
available information mutual fund managers rely
on to pick stocks, their average returns should be
the same as those of the average investor in the
market as a whole
 Strong Form EMH
 With the strong form, insider information can
make others not to acquire information.
 However, if mandated to release the information
through publication or submitting to the relevant
board, the information can be acquired by anyone
and thus strong form will still be valid
 Markets have no memory – Today‟s activities will not
be affected by past information (Weak Form EMH)
 Trust market prices – Market prices impound all
available information about the value of each item
 Read the entrails – Read current situation to plan for
the unforeseen
 There are no financial illusions – wrong financial
records cannot exist
 Do it yourself alternative – what investors can do
equally well, they do it themselves
 Seen one stock, seen them all – stocks are
substitutes
 Brealey, R. A., Myers, S. C., & Allen, F. (2014). Principles of
Corporate Finance (11th ed.). New York: McGrall Hill/Irwin.

 Ross, S. A., Westerfield, R. A., Jaffe, J., & Jordan, B. D.

(2016). Corporate Finance (11th ed.). New York: McGraw-
Hill.