CHAPTER ELEVEN

THE EFFICIENT MARKET HYPOTHESIS

CHAPTER OVERVIEW
This chapter examines the concept of market efficiency— securities are fairly priced and an investor
cannot expect to outperform the market, risk-adjusted, consistently over time. The implications of market
efficiency for investors and studies of the efficient capital hypothesis are presented in detail.

LEARNING OBJECTIVES
After studying this chapter, the student should thoroughly understand the concept of market efficiency
and how to make rational investment decisions based upon efficient markets. The student also should
have a thorough understanding of the many tests of market efficiency, the forms of market efficiency, and
observed market anomalies.

PRESENTATION OF MATERIAL
11.1 Random Walks and Efficient Markets
The basic notion of an efficient market is addressed in this first section. The issue of efficiency centers
on stock prices reflecting information. The notion of market efficiency is important in corporate finance
as well as in investments. If markets are highly efficient, investors can be more certain that stock prices
are accurate or that stocks are fairly priced.

Figures 11.1 and 11.2 illustrate price reaction to information. Figure 11.1 shows reaction over a long
period of time as companies are identified as target companies in take-over attempts. Figure 11.2 shows
reactions of security prices to news on the “Midday Call” on CNBC.

The concept of market efficiency is related to the concept of competition. In efficient markets, once
information becomes available, participants will trade quickly on that information. Competition assures
that prices will reflect the information very quickly. If the information does not become incorporated into
price very quickly, market participants would act to eliminate the inefficiency.

The forms of the efficient market are then presented. In a weak-form efficient market, prices will reflect
all information that can be derived from trading data such as prices and volumes. In a semi-strong-form
market, prices will reflect all publicly available information regarding the firm’s prospects. In a strong-
form market, prices would reflect all information relevant to the firms' prospects, even inside information.
All versions assert that prices should reflect all available information and we can typically expect them to
be correct.
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11.2 Implications of the EMH
The implications for the different forms of market efficiency are covered in this section. If markets are
weak-form efficient, technical analysis such as charting, should not result in superior profits. If markets
are semi-strong-form efficient, fundamental analysis should not result in consistent superior profits. If
markets are efficient, investors would tend to employ passive strategies such as buying indexed funds or
employing a buy and hold strategy. The concept of resistance levels or support levels are discussed in
Example 11.2. Fundamental analysis uses earnings and dividend prospects, expectations of future
earnings, and risk evaluation to determine proper stock prices. Active management, including security
selection and market timing, would not result in consistently superior profits if markets are efficient. A
passive investment strategy makes no attempt to outsmart the market.

Even when markets are efficient, portfolio management is useful. The appropriate risk level will vary
over an investor's life. Tax considerations will call for different types of securities to be included in the
portfolio. Other considerations could be related to reinvestment risk associated with cash flow or
considerations related to diversifying employment related risk.

11.3 Event Studies

The major types of tests that researchers have done on market efficiency are described in this section.
Event studies on all types of information have been conducted. If markets are somewhat inefficient, then
professionals who spend considerable resources in investment should secure superior performance, as
expressed by Equations 11.1 and 11.2 and are measured over time as cumulative abnormal returns (CAR).
Example 11.5 uses abnormal returns to infer damages.

11.4 Are Markets Efficient?

The major issues related to examining the results of tests are displayed in this section. In addition to the
issues of magnitude, selection bias and lucky event issues, model misspecification can be an issue. Most
tests show that the markets are quite efficient. Studies show weak serial correlation but some evidence
exist which supports momentum across sectors. Some studies show broad market returns can be predicted
by factors such as dividend ratios, earnings yield and bond spreads. Anomalies do exist. Students can
discuss the difference between anomalies and the ability to profit from these anomalies in the context of
efficiency.

Analytical work that has been done on interpreting anomalies indicates that some of the return may be a
risk premium that is not reflected in the market model. Figures 11.3 through 11.6 graph the results of
performance studies that seem to support anomalies. This section closes with a presentation on bubbles
and market efficiency. Discussions on the small-firm effect, neglected-firm, and liquidity effects are
discussed followed by post-earnings-announcement and interpreting anomalies.

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of McGraw-Hill Education.
11.5 Mutual Fund and Analyst Performance
The results on performance of analysts show some positive abnormal performance but trading costs
following analysts’ recommendation may eliminate any excess profits. Some recent studies on mutual
funds have documented some persistence in positive and negative performance, for example Figure 11.7.
Figure 11.8 illustrates risk-adjusted performance in ranking quarter and post-ranking quarter. Some
researchers question whether the performance in abnormal or whether the studies have measurement
errors. The evidence shows that some superstars exist. The results indicate some persistence but not
overwhelming evidence of consistent abnormal returns.

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.