20220910171334HCTAN008C9-Topic 9-Transmission of Info

Topic 9: Financial markets – Transm ission of Inform ation
Topic 9:
Financial markets –
Transmission of Information
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Either Section A or B Exam focus + outline

Topic 9:
Efficient Mkt Hypothesis
[EMH]
3 Types of Efficiency [6-9m] Derive __________[7-10m]
_____________ efficiency ___________Return [5-7m]

Valuation efficiency Joint Hypothesis Problem [4-7m]
[6-7m]
Allocative efficiency
[8-15m] Arguments for EMH Arguments against

Random Walk Behavior 1) small firm effect
Technical analysis 2) Calendar effect, January/Monday/ Daily effects
3) Mean reversion
Semi-strong Earnings (or dividend) market overreaction **
announcement market underreaction**
Mutual fund manager Corporate insider
T9-pg1
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Outline for Topic 9

1. Types of efficiency:
1) Valuation efficiency
2) Informational efficiency
3) Allocative efficiency
2. Excess Returns, Optimal Forecast of Returns
3. Efficient Market Hypothesis (EMH)

(1) weak-form efficiency
(2) Semi-strong-form efficiency
(3) Strong-form efficiency
4. Implications of EMH for weak, semi-strong, strong-form efficiency
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Outline for Topic 9

5. Empirical Evidence On Efficient Markets
(i) Random Walk & Technical Analysis (weak-form Efficiency)
(ii) Earnings Announcements (Semi-strong-form Efficiency)
(iii) Mutual Fund Performance (Strong-form Efficiency)
6. Empirical Evidence against market efficiency

– Small firm effect and Calendar Effects (weak-form efficiency)
– Market overreaction & Under-reaction (semi-strong-form efficiency)
– Corporate insiders (strong-form efficiency)
T9-pg2
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Learning outcomes
• To investigate whether stock prices reflect all available information

in financial markets
• To discuss efficient market hypothesis (EMH)
• To explain excess returns in information efficient markets
• To describe the 3 forms (weak/semi-strong/ strong) of market efficiency
• To discuss the arguments for and against the of 3 forms of efficiency
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Part A:
Types of Efficiency
informational efficiency
valuation efficiency
allocative efficiency
Derive the Efficient Hypothesis Theory (EMH)
Excess Return
Joint Hypothesis Problem
Part B
3 forms & implications of EMH
weak-form, semi-strong form and strong-form
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Empirical evidence in favour of and against the EMH
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Topic 9- Transmission of Information [EMH] Key concept
3 types of Efficiency* [6-9 marks]

1) Valuation Efficiency [general] Security P reflect fair/ intrinsic / fundamental value
+2) Informational Efficiency* [specific] Security P reflect all available info [Efficient mkt]
=3) Allocative Efficiency
Mkt allocate productive resources [$] to the
most productive investment
Importance of Informational Efficiency

goal of the firm  is to maximise shareholder wealth
Financial mkt need to reflect the ___________________ correctly

Firm can make correct [capital] investment decision
Derive* [7-10 marks]

Theoretical Framework of Informational Efficient mkt Hypothesis [EMH]
Div capital gain
E(R ) = C + [Pt+1 – Pt] E(R) = expected return
% Pt E(R*) = ______________ expected return
Quantity demand = Quantity supply
Efficient market
Expected return = forecast return [RF ]
E(R) = RF
E(R) = E(R*)
E(R) = E(R*) = RF = C + (Pt+1- Pt)
Pt
Efficiency
• A financial market is informational efficient when security prices fully reflect
all available information.
• Efficiency means whether the securities prices reflect the true fundamental
(i.e. intrinsic or fair) value of the securities.
• Types of efficiency:
T9-pg4
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Efficiency
• all prices are always correct and reflect market fundamentals.
• The market price of a security is the fair price and
• It is the expected cash flows from the security using all relevant information.
- more specific form of efficiency than valuation efficiency
- assumes expectations are optimal forecasts using all available information,
(but not that market prices reflect the fair value).
= Valuation efficiency + Informational efficiency
• whether a market allocates resources to the most productive investments
in channeling funds from saver-lenders to spender borrowers.
• Asset prices reflect the discounted stream of future cash flows accurately.
• Asset prices signal directing resources
(i) from savers into the common stocks yielding the highest returns and
(ii) from firms into the real assets yielding the highest returns. 9
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Concept Check Activity:

3 Types of Efficiency
Efficiency = A financial market is in__________ efficient when security prices fully reflect all
availableinformation. Efficiency means whether the securities prices reflect the true
fundamental (i.e. intrinsic or fair) value of the securities.
1) all prices are always correct and reflect market fundamentals. The market
V__________ price of a security is the fair price and It is the expected cash flows from the
Efficiency security using all relevant information.
2) more specific form of efficiency than valuation efficiency

In__________ assumes expectations are optimal forecasts using all available information,
Efficiency (but not that market prices reflect the fair value).
3) = Valuation efficiency + Informational efficiency
A____________ whether a market allocates resources to the most productive investments
_ in channeling funds from saver-lenders to spenderborrowers.
efficiency Asset prices reflect the discounted stream of future cash flows accurately.
Asset prices signal directing resources
(i) from savers into the common stocks yielding the highest returns and
T9-pg5
(ii) from firms into the real assets yielding the highest returns. 10
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Exam Focus
PYQ-QA9- Transmission of Information
1 Explain what is meant by informational efficiency, valuation efficiency and2009-7a-ZB
allocative efficiency. (6 marks)
2 Explain the difference between valuation efficiency, informational2015-4a-ZAB
efficiency and allocative efficiency. (8 marks)
3 Distinguish between informational efficiency, valuation efficiency and2011-1a-ZA
allocative efficiency. (9 marks)
4 Distinguish between informational efficiency, valuation efficiency and2021-8b-ZA
allocative efficiency. (9 marks) online
5 Distinguish between valuation, allocative and informational efficiency in2017-4a-ZAB
relation to financial markets. Explain why allocative efficiency depends upon
the existence of valuation and informational efficiency. (10 marks)
6 Explain why the concept of informational efficiency is important in capital2009-7c-ZB
budgeting and portfolio management. (9 marks)
7 Discuss why the assumption of informationally efficient markets is important2012-8a-ZB
for traditional capital budgeting and asset pricing. (7 marks)
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7. (a) Explain what is meant by informational efficiency, valuation efficiency

and allocative efficiency. (6 marks)
7(a) refer to pp.164–65 of the subject guide
20097a
• A financial market is referred to as informational efficient, when security prices
fully reflect all available information.
• Informational efficiency is a more specific form of the general
valuation efficiency, which refers to whether the prices of the securities traded on a
market reflect the true fundamental (also termed intrinsic or fair) value of the
securities. Under valuation efficiency, all prices are always correct, and reflect
market fundamentals (items that have a direct impact on future cash flows of the
security). Therefore, the market price of a security is the fair price, and has to be
equal to the expected cash flows from the security using all relevant information.
Informational efficiency is a more specific form than valuation efficiency, because
it assumes that expectations are optimal forecasts using all available
information, but not that market prices reflect the fair value.
• Valuation efficiency and informational efficiency are conditions for the achievement of
the most general efficiency condition of financial markets: allocative efficiency. This
refers to whether a market allocates productive resources to most productive
investments in performing its main function of channelling funds from saver-lenders T9-pg6
to spender-borrowers. 12
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Evidence on market efficiency (Fama’s 1970)

• The primary role of the capital market is to allocate capital stock.
• Market prices provide accurate signals for resource allocation.
• In efficient market, prices always ‘fully reflect’ all available information, i.e.
firms can make production investment decisions &
investors can choose the securities that represent ownership of firms’
activities
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Informational Efficient Markets

The importance of informational efficient markets
• The main objective of capital budgeting is to maximise shareholder wealth,
(by maximizing the value of the firm’s stocks).
so, it is important for the financial markets to value the stocks correctly.
The signal given by the financial market to the stockholders
(through the price) has to reflect the firm’s decisions on investment projects
in a correct way.
• If financial markets were inefficient,
then managers cannot make rational capital investment decisions
as unable to identify the opportunity cost of capital for the NPV calculation.
• Portfolio theory assumes that financial market is efficient.
If a financial market is inefficient in pricing securities, then the equilibrium
return (measured by the CAPM or APT) would lose credibility.
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7(c) Explain why the concept of informational efficiency

is important in capital budgeting and portfolio management. (9 marks)
7(c) refer to p.165 of the subject guide. 20097c
• the main objective of capital budgeting (i.e. to maximise shareholder wealth

and therefore to maximise the value of the firm’s stocks), it follows that it is
important that financial markets are able to value the firm’s stocks correctly. The
signal given by the financial market to the stockholders (through the price) has to
reflect the firm’s decisions on investment projects in a correct way.
• capital budgeting techniques use a discount rate for the appraisal of real assets,
if financial markets were inefficient, it would be virtually impossible for managers
to take rational capital investment decisions on behalf of stockholders because it
would be impossible to identify the opportunity cost of capital to be used in the
NPV calculation. Therefore different investments with the same degree of risk
could generate different rates of return, and the managers would not be able to
choose the best available forgone rate of return.
• one main assumption in portfolio theory is that a financial market is reasonably
efficient, if a financial market is inefficient in pricing securities, then the
equilibrium return (measured by the CAPM or the APT) would lose credibility. 15
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Part A:
Types of Efficiency
Excess Return
Part B
Empirical evidence in favour of and against the EMH 16 T9-pg8
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Informational Efficient Markets

• informational efficiency refers to individual markets
(not to the markets as a whole).
• e.g. market A can be efficient, but market B can be inefficient.
• the reference is mainly to financial markets, because of their nature
(low transaction costs, continuous trading by skilled operators,&
nature of the pay-offs perceived on securities traded in these markets).
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A Theoretical Framework
• Equation for every financial asset (both bonds & stocks) in any period t to t+1
by writing the following equation:
(9.1)
where:
C = cash flow from the security (dividend or coupon) in the period t to t+1
Pt = price of the security at time t
Pt+1 = price of the security at time t+1.
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Efficient Market Hypothesis (EMH)

In efficient markets, security prices incorporate all available information.
• Expected value = forecasted value using all available information.
• Expected return, E(R) on a security
= optimal forecast of the return using all available information (RF), i.e.
• In equilibrium (i.e. quantity of securities demanded = quantity supplied),
Expected Return (E(R)) = Equilibrium return (E(R*)), (equation 9.2)
derived from CAPM or APT.
Efficient market assumes that a fair price (i.e. equilibrium price, ER*) exists
• To describe the pricing behaviour in efficient markets, (equation 9.3)
replace E(R) with E(R*) in (9.2), get: (equation 9.4)
• i.e. current prices have to be set as
optimal forecast of a security return = expected return in equilibrium.
• i.e. in efficient markets security prices fully reflect all available information
(equation 9.5)
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Exam Focus
8 Theoretically derive the efficient market hypothesis. (10m 2008-10a-ZB
9 Theoretically derive the efficient market hypothesis. (7 marks) 2014-7a-ZAB
10 Theoretically derive and explain the efficient markets hypothesis. (9m) 2021-8a-ZA
11 Theoretically derive a framework to analyze whether markets are2009-7b-ZB
informationally efficient. (10 marks)
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10. (a) Theoretically derive the efficient market hypothesis. (10 marks)
10(a) refer to pp.143–144 of the subject guide. 200810a
• equation for every financial asset (both bonds and stocks)

in any period t to t + 1 by writing the following equation:
(1)
where:
C = cash flow received from the security (dividend or coupon) in the period t to t + 1
Pt = price of the security at time t
Pt+1 = Price of the security at time t + 1
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• the efficient market hypothesis (EMH) assumes that financial markets are
efficient when security prices incorporate all available information. Therefore,
in efficient markets the expected value has to be equal to the forecasted
value using all available information. This means that in efficient markets the
expected return on a security (E(R)) will equal be to the optimal forecast of
the return using all available information (RF). 200810a
(2)
• although we cannot observe the expected return, we know how to measure
the value of E(R). Therefore equation (2) has important implications for how
prices of securities change on financial markets. As in equilibrium (when the
quantity of securities demanded is equal to the quantity supplied), the
expected return (E(R)) equals the equilibrium return (E(R*)), derived either
with the Capital Asset Pricing Model (CAPM) or the Asset Pricing Theory
(APT). Implicit in the notion of efficient market is the assumption that a fair
price for a security exists. This fair price is known as the equilibrium price.
Formally, in equilibrium:
(3)
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Part A:
Types of Efficiency
Excess Return
Part B
Empirical evidence in favour of and against the EMH 23
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Excess Return ** Actual return - Equilibirum return

=____________ Return = Rx = Rt – E(R*) Key concept
Rx = RF – E(R*)
RF = Optimal forecast return
Stock A vs Stock BCD

Actual return (10%) < 20% _________ return
Price Stock A > Price Stock BCD
Investor buy more stock BCD _________ Price
 less stock A
 Price Stock A drop drop drop Lower Price
Return up, up, up High return
Security with different risk  different equilibrium return (R*)
Efficient market  NO EXCESS RETURN ___________________
[maybe only have Excess Return occasionally
have ___________ RETURN]

Can get optimal forecast [Rf] return by using all available information
If RF > E(R*) if RF < E(R*)

30% 20% 5% 20%
Good investment [with excess Bad investment
return]  sell this tock
Investor buy more this stock P drop, drop, drop
P up, up, up RF up,up, up
Return down, down, down Until RF = E(R*)
Until RF = (R*) T9-pg12
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Sell =$55 Extra info
Investor A investor B
Buy $30 [high P] buy $20 [low P]
Return = 55-30 = 25 [____ return] Return = 55-20 = 35 [______ return]
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Excess Returns
• fundamental valuation formula, (i.e. market equilibrium)
(equation 9.1)
• If actual return of a stock < return on other securities of equivalent risk

 actual price > fair price.
• If actual return (10%) and expected return (20%),
investors would shift their capital to other securities. This process would
decrease the current price of the stock, & increasing its actual return.
• If the actual return (40%) > expected return (20%) actual price < fair price
 with excess return, investors would buy more of this stock
(i.e. drive up its actual price relative to the fair price).
T9-pg13
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Excess Returns
= abnormal return =unexploited profit opportunity =risk adjusted returns
- Use CAPM & APT to find the excess return.
• Equilibrium price = required return of a security
• Securities with different risk have different equilibrium return.
• Market model recognizes that some stocks are more affected than others by
fluctuations in the market.
• It estimates the expected return on a stock by
regressing actual returns on the stock against those of the market.
• Excess return measures abstracts from changes in the stock prices
resulting from marketwide influences.
Excess return = actual return - equilibrium expected return.
Excess return =Rtx = Rt -E(R*t) (equation 9.6)
Where:
Rt = actual return on the market at time t
E(R*t) = expected equilibrium return at time t 27
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Excess Returns
• define excess return by replacing the
actual return of a security with the optimal forecast return.
• Excess return =Optimal forecast of the return -Expected return in equilibrium:
• (equation 9.7)
• In efficient market,
no investor can make excess returns,
based on the available information.
They can only earn normal returns (i.e. equilibrium returns).
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Activity 9.1
• The actual return on stock ABC is 10%, and the equilibrium return is 12%.
a) What is the excess rate of return on stock ABC?
b) What if the actual return was 15%? Rtx = Rt -E(R*t)
Solution Excess return = Actual return – Eqm return
a) Excess rate of return on stock ABC is negative (–2%),

when the actual return is 10% and the equilibrium return is 12%.
b) It becomes positive (+3%) if the actual return is 15%.
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Optimal Forecast of Returns

• Optimal forecast of return using all available information (RF).
• The excess return notion still holds.
For Example
(i) If optimal forecast of the return (30%), equilibrium return (15%)
good investment with excess return [i.e. R F>E(R*)]
investors would buy more of this stock (in an efficient market)
drive up its current price (relative to the expected future price)
lowering RF.
When the current price has increased sufficiently until RF=E(R*),
the efficient market condition is satisfied.
(ii) if the optimal forecast of the return (5%), equilibrium return (10%)
 poor investment [i.e. RF<E(R*)].
investors would sell the stock,
drive down its current price (relative to the expected future price)
T9-pg15
optimal forecast of the return will increase until RF=E(R*). 31
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Excess Returns
= _______ return =unexploited profit opportunity = risk adjusted returns
= _______ return – equilibrium _____________return = Rtx = Rt -E(R*t)

- Equilibrium price = required return of a security
• Securities with different risk have different equilibrium return.
• Market model recognizes that some stocks are more affected than others by fluctuations in
the market. It estimates the expected return on a stock by regressing actual returns on the
stock against those of the market.
• Excess return measures abstracts from changes in the stock prices
resulting from marketwide influences.
actual price < fair price Actual return (40%) > expected return (20%)
 with excess return investors would buy more of this stock
(i.e. drive up its actual price relative to the fair price).
Actual price > Fair price Actual Return (10%) < Expected Return (20%)
no excess return Actual Return (stock) < ER (other securities of equivalent risk)
 investors would shift their capital to other securities. This would decrease
the current price of the stock, & increasing its actual return. 32
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Exam Focus
12 What are excess (abnormal) returns? 20074a-ZAB
Can excess returns be earned in efficient markets? (5 marks)
13 Explain what an excess return is in a financial market. Explain why in an2010-8b-ZB
informationally efficient market investors are not able to make consistent
excess returns. (6 marks)
14 Explain what an excess return is in a financial market. Explain why, in an2016-2b-ZAB
informationally efficient market, investors are not able to obtain consistent
excess returns. (6 marks)
15 Describe the concept of an excess return and explain how this could be2015-4b-ZB
calculated in the context of testing for informational efficiency in markets. (7m
16 Explain and theoretically derive the concept of excess return and 2008-10b-ZB
the optimal forecast of return using all available information. (9 marks)
17 Discuss the concept of excess return in the context of testing the2012-8d-ZB
efficient market hypothesis. (7 marks)
18 Explain what an excess return is in a financial market.2014-7b-ZAB
Discuss the main predictions of the efficient markets hypothesis. (6 m) T9-pg16
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4. (a) What are excess (abnormal) returns?

Can excess returns be earned in efficient markets? (5 marks) 20074a
• refer to page 145 of the subject guide.

• Excellent students would answer that Rtx = Rt -E(R*t)
excess returns can be calculated as the difference between the
actual return on the market and the equilibrium expected return.
• The excess return at time t (Rt X) is:
where
Rt = actual return on the market at time t;
E(Rt) = expected equilibrium return at time t.
In an efficient market, no investor can make excess returns

based on the available set of information.
They can only earn normal returns, which here means equilibrium returns.
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• To describe the pricing behaviour in efficient markets, we can replace E(R)

with E(R*) in equation (2). Thus we obtain: 200810a
(4)
• equation (4) means that current prices in financial markets have to be set so
that the optimal forecast of a security return equals the expected return in
equilibrium.
• in efficient markets security prices fully reflect all available information.
Therefore from equation (1):
(5)
T9-pg17
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Part A:
Types of Efficiency
Excess Return
Part B
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Joint Hypothesis Problem * [4-7 marks]  EMH is untestable Key concept

[Dual]
•_________ is untestable in the ___________________ mkt portfolio
* _________ does not tell the underlying factor
unknown whether the mkt is efficient or inefficient

test is affected by 2 problems- (i) informational efficiency
(ii) accuracy of E(R*)
T9-pg18
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• EMH is untestable due to the joint hypothesis problem of CAPM & APT.
• CAPM is untestable in the unobservable market portfolio.
• APT does not tell us what the underlying factors
• So, using CAPM & APT may be wrong in adjusting
actual returns in the excess return calculation.
• This implies that abnormal returns may be incorrectly quantified,
and then used in the test of the efficient market hypothesis.
The test is affected by 2 problems:
a. informational efficiency
b. accuracy of the equilibrium expected returns. E(R* )
t
• If the test indicates the presence of excess return markets are inefficient.
• However, the market inefficiency could be due to the
wrong excess return measurement.
• so it remains unknown whether the market is efficient or inefficient
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Joint [= ] Hypothesis Problem
• EMH is untestable due to the joint hypothesis problem of ___________&
________.
• CAPM is untestable in the unobservable market portfolio.
• APT does not tell us what the underlying factors
• Using CAPM & APT may be wrong in adjusting actual returns in the excess
return calculation. This implies that abnormal returns may be incorrectly
quantified, and then used in the test of the efficient market hypothesis.
• The test is affected by 2 problems:
(a) informational efficiency &
(b) accuratecy of the equilibrium expected returns.
• If the test indicates the presence of excess return markets are inefficient.
• However, the market inefficiency could be due to the wrong excess return
measurement. so it remains unknown whether the market is efficient or
inefficient T9-pg19
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Exam Focus
19 Discuss the joint hypothesis problem. (6 marks) 2008-10c-Zb
20 Explain how the joint hypothesis problem affects empirical 2010-8c-ZB
testing of the efficient markets hypothesis. (5 marks)
21 Explain the joint hypothesis problem in relation to 2011-4c-ZA
testing efficiency of financial markets. (7 marks)
22 Discuss the joint hypothesis problem in the context of 2014-7c-ZA
testing the efficient markets hypothesis. (6 marks)
23 Explain the joint hypothesis problem in relation to 2021-8c-ZA
testing efficiency of financial markets. (7 marks) online
24 Explain the dual hypothesis problem in the context of 2012-8d-ZB
testing the efficient market hypothesis. (4 marks)
25 Explain the joint-hypothesis problem encountered when 2015-4b-ZA
testing for informational efficiency of a market. (7 marks)
26 Explain the joint-hypothesis problem encountered when 2018-3b-
testing for informational efficiency of a market. (7 marks) ZAB
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10(c) Discuss the joint hypothesis problem. (6 marks)

(c) refer to p.146 of the subject guide. 200810c
• identify the logical link between parts (b) and (c) of this question. In fact, the
choice of the model used to adjust actual returns in the
excess return calculation may be wrong.
• Hence abnormal returns may be incorrectly quantified, and
then used in the test of the efficient market hypothesis.
• This implies that the same efficient market hypothesis would become
untestable because of the joint hypothesis problem.
• Then candidates should go on to discuss this in more detail to show that they
understand the statement made here above.
• The test is affected by two problems:
a. informational efficiency
b. accuracy of the equilibrium expected returns
T9-pg20
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• If the test indicates the presence of excess return, this would imply that
markets are inefficient. However, the inefficiency of the markets could be
determined by the use of an incorrect technique for the measurement of the
excess return. Therefore we do not know whether the market is efficient but
either the excess return measurement is wrong, or the market is actually
inefficient. 200810c
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Part A:
Types of Efficiency
Excess Return
Part B
43 T9-pg21
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Efficient market Key concept

Security P reflect all information, so unable to beat the market
NO EXCESS RETURN (= no abnormal return)
Only have NORMAL RETURN
___________nature of the 3 forms of EMH
3 Forms Stock Price fully reflect Implication

of EMH
Weak Cannot use
Form _____________ information technical analysis
(eg. past price, past return, past information)
Semi- + historical information Cannot use
strong technical analysis
form + _________ information (e.g. financial accounts, + fundamental analysis
financial press, company announcement)
Strong +historical information Fund manager CANNOT get
Form + public information insider information
NOBODY have
+ _________ information (= private information) information advantage
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Levels Of Informational Market Efficiency

Efficient market
~ market without excess returns based on the available information.
3 forms of market efficiency (by Fama,1970):
1) Weak form efficiency
2) Semi-strong form efficiency
3) Strong form efficiency
• Semi-strong information set contains the weak-form set
• Strong form information set contains the weak form & semi-strong form.
(1) Weak-form efficiency:

~ prices fully reflect all historical information (e.g. past prices & returns,
past data on the financial characteristics of the firms, &
information on macroeconomic conditions).
T9-pg22
- investors are unable to make excess returns consistently using past data.45
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(3) Strong Form Efficiency

(2) Semi-strong-form efficiency:
• prices fully, accurately and speedily reflect all past & new public information.
• new public information (e.g. financial accounts, company announcements
and information in the financial press).
• investors are unable to make excess returns using public information
because this information will already be reflected in the security prices.
(3) Strong-form efficiency:

~ prices reflect all public & private information.
- Private information include insider information
(e.g. a company’s directors informed about future merger & acquisition plans),
and information analyzed by investors & analysts (e.g. managers of mutual
funds).
- investor is unable to earn excess returns based on any information available.
- As unable to beat the market consistently,
- so no point in paying for specialist advice
- because no one can have an information advantage. 46
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3 Levels of Informational Market Efficiency
Efficient market = market without excess returns based on the available information.
W___________ prices fully reflect all h___________ information (e.g. past prices & returns,
form efficiency past data on the financial characteristics of the firms, & information on
macroeconomic conditions). investors are unable to make excess returns
consistently using past data.
S____-s______ prices fully, accurately and speedily reflect all p_______ & new p________
form efficiency information. new public information (e.g. financial accounts, company
announcements and information in the financial press). investors are unable
to make excess returns using public information because this information will
already be reflected in the security prices.
S___________ prices reflect all p___________ & ___________information.

form efficiency Private information include insider information (e.g. a company’s directors
informed about future merger & acquisition plans), and information analyzed
by investors & analysts (e.g. managers of mutual funds). investor is unable to
earn excess returns based on any information available. As unable to beat
the market consistently, so no point in paying for specialist advice because
no one can have an information advantage
T9-pg23
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Exam Focus
27 Name and briefly describe the three types of market efficiency(6 m 20074b-ZAB
28 Describe and distinguish between the 3 types of efficiency proposed by Fama (1970).2012-8c-ZB
(7 marks)
29 Distinguish between weak-form, semi-strong form and strong-form levels of market2014-7d-ZA
efficiency. (6 marks)
30 Discuss the implications of the EMH for investors.(6 marks) 2021-8b-ZB
31 Distinguish between weak-form, semi-strong form and strong-form levels of market2010-8a-ZB
efficiency. Discuss the implications of weak and semi-strong form efficient equity
markets for investors in equity securities. (6)
32 Distinguish between weak-form, semi-strong form and strong-form levels of market2016-1a-ZAB
efficiency. Discuss the implications of weak, semi-strong and strong form efficient
equity markets for investors in equity securities. (6 marks)
33 Distinguish between weak-form, semi-strong form and strong-form levels of market2018-3a-ZAB
efficiency. Discuss the implications of weak, semi-strong and strong form efficient
equity markets for investors. (6 marks)
34 Explain the concept of the Efficient Markets Hypothesis (EMH) and2021-8a-ZB
explain why prices should reflect all available information. (5 marks)
48
48
7(d) Distinguish between weak-form, semi-strong form and strong-form levels

of market efficiency. (6 marks) 2014-7d-ZA
See subject guide, Chapter 9, section headed ‘Levels of informational market
efficiency’.
Approaching the question
The three levels of market efficiency, introduced by Fama (1970) are weak form,
semi-strong form and strong form. Each relates to particular information sets:
• Weak form – prices reflect historical information
• Semi-strong form – prices reflect all public information
• Strong form – prices reflect both public and private information.
The three forms are nestedso that if a market is semi-strong efficient, it

must also be weak-form efficient.
T9-pg24
49
49
Short Question
1. Discuss the various forms of market efficiency.
Include in your discussion the information sets involved in each form and the
relationships across information sets and across forms of market efficiency.
Also discuss the implications for the various forms of market efficiency for
the various types of securities' analysts.
• The weak form of the efficient markets hypothesis (EMH) states that stock
prices immediately reflect market data. Market data refers to stock prices and
trading volume. Technicians attempt to predict future stock prices based on
historic stock price movements. Thus, if the weak form of the EMH holds, the
work of the technician is of no value.
• The semi-strong form of the EMH states that stock prices include all public
information. This public information includes market data and all other
publicly available information, such as financial statements, and all
information reported in the press relevant to the firm. Thus, market
information is a subset of all public information. As a result, if the semi‐strong
form of the EMH holds, the weak form must hold also. If the semi‐strong form
holds, then the fundamentalist, who attempts to identify undervalued
securities by analyzing public information, is unlikely to do so consistently
over time. In fact, the work of the fundamentalist may make the markets even
more efficient!
50
• The strong form of the EMH states that all information (public and
private) is immediately reflected in stock prices. Public information is a
subset of all information, thus if the strong form of the EMH holds, the
semi‐strong form must hold also. The strong form of EMH states that
even with inside (legal or illegal) information, one cannot expect to
outperform the market consistently over time.
• Studies have shown the weak form to hold, when transactions costs are
considered. Studies have shown the semi‐strong form to hold in general,
although some anomalies have been observed. Studies have shown that
some insiders (specialists, major shareholders, major corporate officers)
do outperform the market.
T9-pg25
51
Implications of EMH
Implications of EMH in security analysis & trading
Implication 1 – weak-form efficient market
• investors are unable to get excess returns from past prices
because current market stock prices would reflect past information, thus
cannot use technical analysis to identify mispriced securities.
(i.e. past information is already reflected in current prices)
Technical analysis
~ analyse the charts of stock price movements
to discover particular recurrent patterns (e.g. trends or cycles).
• When technical analysts realise that one of these patterns is starting to
develop for a specific stock, they believe they are able to predict future stock
prices.
52
52
20108d
Levels Of Informational Market Efficiency 2016-2a-ZAB
2018-3a-ZAB
Implication 2: semi-strong efficient market
• it is worthless to trade securities based on publicly available information.
• It is worthless to use technical analysis & fundamental analysis
(as publicly available information are already reflected in market prices).
Fundamental analysis
~ analyze publicly available information to determine the intrinsic value of a firm
on the basis of the company, the industry & the general economy.
• Then compare the intrinsic value with the market price
to provide investment recommendation (i.e. to buy/ sell/ hold).
Implication 3: Strong-form efficient market

• investors are unable to get excess returns from inside information
because stock prices would reflect all public & private information.
- Fund managers with superior forecasting will not lead to abnormal profits,
T9-pg26
as fund managers cannot possess private information. 53
53
25 Distinguish between weak-form, semi-strong form and strong-2010-8a-ZB

form levels of market efficiency.
Discuss the implications of weak and semi-strong form efficient
equity markets for investors in equity securities. (6)
26 Distinguish between weak-form, semi-strong form and strong-2016-1a-ZAB
form levels of market efficiency.
Discuss the implications of weak, semi-strong and strong form
efficient equity markets for investors in equity securities. (6
marks)
27 3(a) Distinguish between weak-form, semi-strong form and2018-3a-
strong-form levels of market efficiency. ZAB
Discuss the implications of weak, semi-strong and strong form
efficient equity markets for investors. (6 marks)
28 Name and briefly describe the three types of market20074b-ZAB
efficiency(6 m
29 Describe and distinguish between the 3 types of efficiency2012-8c-ZB
proposed by Fama (1970). (7 marks)
30 Distinguish between weak-form, semi-strong form and strong-2014-7d-ZA
form levels of market efficiency. (6 marks) 54
54
3(a) Distinguish between weak-form, semi-strong form and strong-form

levels of market efficiency. Discuss the implications of weak, semi-strong and
strong form efficient equity markets for investors. (6 marks)
• See subject guide, Chapter 9, pages 189{90. 2018-3a-ZAB
• Weak-form - prices fully reect all historical information.
• Semi-strong form - prices reflect all public information.
• Strong-form - prices reect all public and private information.
• Better answers would dene what each of these information sets is and
explain that the wider information sets nest the less-wide sets (for example,
the semi-strong information set nests the weak set).
• The implications of weak-form efficiency for investors are that investors
cannot use models/technical analysis based on past data to predict future
prices.
• The implications of semi-strong efficiency are that investors cannot use
fundamental analysis to try to pick undervalued securities.
• The implications of strong-form efficiency are that excess returns cannot
be obtained by using private information { for example, superior forecasting
ability. - T9-pg27
55
Part A:
Types of Efficiency
Excess Return
Part B
- Weak form
- Semi- strong form 56
56
Key concept
Empirical Evidence to Support EMH Empirical Evidence Not to Support EMH
Arguments for EMH Arguments against EMH/ inconsistent with EMH
[investor cannot get Excess Return] [Investors can get Excess Return] [Anomalies]
WEAK FORM WEAK FORM
i) _______________________ Behavior of stock price 1) small firm effect
Stock price move up or down randomly/ freely next period return is positively correlated with previous return
Investor do not know the future prices based on the past Rt+1 R
prices 1) ______________________________ effect
because current market price reflects all information January effect (Jan return is higerh than other 11 months)
Monday effect (low return on Monday)
ii)__________________ analysis Daily effect (most daily return at the beginning or ending
Cannot predict future stock price of the day)
 Cannot outperform the market Jan effect is inconsistent with random walk so Buy stock in
 cannot earn Excess Return Dec & sell in Jan
i) Jan effect with Small firm effect
ii) Taxation impact (tax-selling hypothesis)
Sell shares (with losses) before year end (to
benefit from tax losses)
Reinvest in the following year
1) Mean reversion
Low return (today)  high return (tomorrow)
T9-pg28
 Investor can predict future share P.
57
SEMI-STRONG FORM SEMI-STRONG FORM

Stock price adjust to the new public information rapidly but
______________ (or dividend) announcement NOT Instantaneously Key concept
Stock P move up after good announcement
Stock P reflect the new public information quickly and accurately (a) market ______________________________ **
stock P disproportionately move up [or down] after
good [or bad] news
price error is corrected slowly (even several months)
market overreaction  adjusted gradually
so investors can earn excess return by using
Contrarian Strategy
i.e. buy [or sell] stock immediately after bad [or good]
news sell [or buy] stock several months later
extreme loser portfolio outperform (earn 25% more) than
the extreme winner pfl
(b) market _____________________________**
stock P do not fully incorporate the new information
given in unexpected earnings announcement, so
investor can get excess return in SHORT RUN by
using Momentum Strategy
(i.e. buy good news stock, sell bad news stock)
STRONG FORM STRONG FORM
Mutual fund manager cannot beat the market Corporate insider (i.e. company’s CEO) use insider information.
Investor get Excess Return from trading own firm stock
58

Arguments for EMH Arguments against EMH/ inconsistent with EMH Full Version
WEAK FORM WEAK FORM
i) Random Walk Behavior of stock price 1) small firm effect
Investor do not know the future prices based on the past prices Rt+1 R
because current market price reflects all information 1) Calendar effect
ii)Technical analysis January effect (Jan return is higerh than other 11 months)
Cannot predict future stock price Monday effect (low return on Monday)
 Cannot outperform the market Daily effect (most daily return at the beginning or ending of the day)
 cannot earn Excess Return Jan effect is inconsistent with random walk so Buy stock in Dec & sell in Jan
Sell shares (with losses) before year end (to benefit from tax losses)
1) Mean reversion
Earnings (or dividend) announcement Stock price adjust to the new public information rapidly but NOT Instantaneously
Stock P move up after good announcement (a) market overreaction **
Stock P reflect the new public information quickly and accurately stock P disproportionately move up [or down] after good [or bad] news
so investors can earn excess return by using Contrarian Strategy
i.e. buy [or sell] stock immediately after bad [or good] news
sell [or buy] stock several months later
extreme loser portfolio outperform (earn 25% more) than the extreme winner pfl
(a) market underreaction**
stock P do not fully incorporate the new information given in unexpected earnings announcement,
so investor can get excess return in SHORT RUN by using Momentum Strategy (i.e. buy good
news stock, sell bad news stock)
STRONG FORM
Mutual fund manager cannot beat the market
STRONG FORM
Corporate insider (i.e. company’s CEO) use insider information.
T9-pg29
59
Empirical Evidence On Efficient Markets

• Many empirical tests on weak- & semi-strong-form efficiency.
Few on strong-form efficiency (as it is more difficult to test it).
• Early empirical provide evidence in favour of weak- & semi-strong forms
60
60
Random Walk Behaviour of Stock Prices &

Weak-form Efficiency
• Security prices follow a random walk (i.e. equally likely to go up or down)

on any particular day regardless of past price movement.
Example – Random Walk
- You are given $1,000 to play a game. At the end of each day a coin is tossed.
- If it comes up heads, you win 4% of your investment; if it is tails, you lose 3%.
- At the end of the 1st day it is equally likely to have heads or tails.
- So your capital at the end of the 1st day can equally be $1,004 or $997.
- At the end of the 2nd day, the coin is tossed again.
- The outcomes associated with the positive 1st-day outcome ($1,004) are
$1,044 or $974.
i.e. random walk because the changes in value are independent of one another.
T9-pg30
61
61
Random Walk Behaviour of Stock Prices &

Weak-form Efficiency
• If security prices follow a random walk,
investors cannot gain information about future prices on the basis of past prices.
• Any information contained in past prices is already reflected in current prices.
(i.e. weak-form efficient market).
• Early empirical evidence rejected the EMH (on whether future stock returns
can be predicted on the basis of current & past changes).
• So confirms that stock prices follow a random walk &
supports weak-form efficiency.

Example
FTSE 100 (UK), Nikkei 500 (Japan),
Standard & Poor’s Composite (USA) DAX 30 (Germany),
62
62
Technical Analysis & Weak-form Efficiency

• Cannot use past stock prices to predict future price changes
because prices of securities follow a random walk.
Technical analysis (which use past data to forecast future stock price
changes) is unable to predict future stock prices successfully &
unable to generate excess return
• In fact, if investors observed the existence of such trading rules generating
excess returns, then they would adopt these rules &
excess returns generated in the past would be eliminated.
This would support market weak-form efficiency.
T9-pg31
63
63
Technical Analysis & Weak-form Efficiency

• Empirical evidence shows that
technical analysis does not outperform the market
• Successful past forecasting does not imply future market outperformance.
• Weak-form efficiency of financial markets is also supported by
Allen and Karjalainen (1999) that returns generated by rules based on
technical analysis do not outperform the market.
• However, weak-form efficiency of financial markets is also NOT supported
by Brock, Lakonishok and LeBaron(1992) who are more favourable towards
technical analysis, & find that such trading rules can generate excess returns.
They observed the success of technical analysis for foreign exchange rates &
the US stock index.
64
64
Exam Focus
35 What is the empirical evidence in favour of and against the2007-4c-ZAB
weak form of market efficiency? (14 marks)
36 Explain weak form efficiency and discuss the empirical evidence in relation2014-7c-ZB
to this form of efficiency. (12 marks)
37 Discuss the evidence relating to weak-form efficiency of equity markets. (12 2018-3c-ZA
38 Describe and discuss the evidence on calendar effects 2009-3b-ZAB
in the context of weak form efficiency.
Refer specifically to the so-called ‘January effect’. (11 marks)
39 Explain the ‘January effect’ in stock markets and 2015-4c-ZA
discuss the evidence for this effect. (10 marks)
T9-pg32
65
65
4(c) What is the empirical evidence in favour of and against the

weak form of market efficiency? (14 marks) 2007-4c-ZAB
• refer to pages 147 and 151–152 of the subject guide. The Examiners would expect
students to begin with the explanation of the empirical evidence in favour of the
weak-form efficiency. The Examiners would award marks for students who
constructed clear paragraphs which made the following points:
• Random walk behaviour of stock prices.
• Technical analysis. Overall empirical evidence shows that
technical analysis does not outperform the market, and that
successful past forecasting does not imply future market outperformance.
This evidence (as provided for example in Allen and Karjalainen, 1999)
supports the weak-form efficiency of financial markets.
Students should also refer to the researchers more favourable to technical analysis
(such as Brock, Lakonishok and LeBaron, 1992),
whose results do not support market efficiency in the weak-form.
Up to 4 marks awarded for showing a good understanding of the evidence on technical analysis.
66
• Students should then move to the investigation of the evidence against weak-form efficiency.
The Examiners would expect students to make the following points:
• Calendar effects. Students should begin with a clear list of the possible calendar
effects, and then focus on the so-called ‘January effect’, which shows that
stocks returns are greater in January than in any other month of the year.
January effect is inconsistent with the random walk behaviour, and
gives strong indications against market weak-form efficiency.
• Small firm effect and weak-form efficiency.
– definition of the phenomenon and then provide the empirical evidence on the
positive correlation of next period’s returns of small firms’ stocks with
previous returns even for weekly and monthly periods (as shown in Lo and
MacKinley, 1988).
– explain the theories that could explain the small firm effect (low liquidity of
small firms or inappropriate measurement of risk for small firm stocks, data-
snooping, and actual weak inefficiency in the USA in the 1970s and the
1980s).
– Up to 3 marks awarded for showing a good understanding of the small firm
effect. T9-pg33
2007-4c-ZAB
67
Earnings Announcements & Semi-strong-form Efficiency

• Semi-strong efficiency implies that
stock prices reflect all publicly available information.

• Semi-strong efficiency related to the changes in stock prices determined by
earnings or dividend announcements
is supported by Ball and Brown (1968).
They studies found that stock price remains unchanged if the information were
publicly available (after positive earnings or dividend announcements).
• The stock price increased in anticipation of the earning/dividend increase, &
once the increase had been announced, the stock price maintained the new
level.
68
68
Earnings Announcements & Semi-strong-form Efficiency

• Some studies of semi-strong efficiency relates to the
speed of stock price adjustment with new & unexpected information
(e.g. earnings announcements, dividends announcements & news of a takeover)
- In a semi-strong efficient market,
stock prices increase (decrease) rapidly to good (bad) news about the firm
when unexpected earnings is higher (lower) than the expected level.
• Ball and Brown (1968) suggests that
new information is quickly & accurately reflected in stock prices.
Unexpected earnings increase (decrease) experienced by the good (bad) news
firms lead to increased (decreased) stock prices.
• Patell and Wolfson (1984) found that the stock price adjustment to
unexpected earnings or dividends announcements is rapid (within 5-10min of
the announcement) T9-pg34
69
69
Mutual Fund Performance & Strong-form Efficiency

• Strong-form efficiency implies that stock prices fully reflect all public & private
available information. Investor cannot beat the market.
• Carhart (1997) suggests that the mutual funds managers do NOT beat the
market. He found that actively managed mutual funds underperform
other broad-based portfolios with similar characteristics
(i.e. 1,500 US mutual funds underperformed in approximately half the years
in 1962- 1992).
• Jensen (1968) and Grinblatt & Titman (1989) found that
mutual funds performed well in the past are UNABLE to beat the
market again in the future.
i.e. in strong-form efficient market, good performance in the past does not
indicate that the mutual fund or investment adviser will
perform well in the future.
• As a result, many mutual fund managers give up managing the fund actively,
turn to simply tracking a benchmark market index, which allow them to
maximize diversification & reduce management costs.
70
70
Part A:
Types of Efficiency
Excess Return
Part B
Empirical evidence in favour of EMH
Empirical evidence against the EMH
- Weak form
- Semi- strong form 71 T9-pg35
71
Key concept
Arguments for EMH Arguments against EMH/ inconsistent with EMH
WEAK FORM WEAK FORM
i) _______________________ Behavior of stock price 1) small firm effect
Investor do not know the future prices based on the past Rt+1 R
prices 1) ______________________________ effect
because current market price reflects all information January effect (Jan return is higerh than other 11 months)
Monday effect (low return on Monday)
ii)__________________ analysis Daily effect (most daily return at the beginning or ending
Cannot predict future stock price of the day)
 Cannot outperform the market Jan effect is inconsistent with random walk so Buy stock in
 cannot earn Excess Return Dec & sell in Jan
Sell shares (with losses) before year end (to
benefit from tax losses)
1) Mean reversion
72

Stock price adjust to the new public information rapidly but
______________ (or dividend) announcement NOT Instantaneously Key concept
Stock P move up after good announcement
Stock P reflect the new public information quickly and accurately (a) market ______________________________ **
stock P disproportionately move up [or down] after
good [or bad] news
so investors can earn excess return by using
Contrarian Strategy
i.e. buy [or sell] stock immediately after bad [or good]
news sell [or buy] stock several months later
extreme loser portfolio outperform (earn 25% more) than
the extreme winner pfl
(b) market _____________________________**
stock P do not fully incorporate the new information
given in unexpected earnings announcement, so
investor can get excess return in SHORT RUN by
using Momentum Strategy
(i.e. buy good news stock, sell bad news stock)
Mutual fund manager cannot beat the market Corporate insider (i.e. company’s CEO) use insider information. T9-pg36
73
January Effect
74
74
Bad news  P down Good news  P up

Over-reacted market Over-reacted market
P down 10% (should) P Should only P up 10%
But P down 50% [drop too much] BUT P up by 50%
In future, In future,
P up 10%, 20%, even 30% P will drop says, by 20%, 30%
So _________ now [when at very low P] Sell now when P are high
= ________________ Strategy Extra Info

=> Excess return available
Bad news  P down Good news  P up

under-reacted market under-reacted market
P should drop 50% P should up 50%
But P only down by 10% But P only up by 10%
[in future In future,
P drop further by 20%, 30%] P will up says, by 20%, 30%
So SELL now
BUY now when P are low
[before P drop to very low] [P will be high in future]
_______________Strategy
(i.e. buy good news stock, T9-pg37
sell bad news stock
75

Arguments for EMH Arguments against EMH/ inconsistent with EMH Full Version
WEAK FORM WEAK FORM
i) Random Walk Behavior of stock price 1) small firm effect
Investor do not know the future prices based on the past prices Rt+1 R
because current market price reflects all information 1) Calendar effect
ii)Technical analysis January effect (Jan return is higerh than other 11 months)
Cannot predict future stock price Monday effect (low return on Monday)
 Cannot outperform the market Daily effect (most daily return at the beginning or ending of the day)
 cannot earn Excess Return Jan effect is inconsistent with random walk so Buy stock in Dec & sell in Jan
Sell shares (with losses) before year end (to benefit from tax losses)
1) Mean reversion
Earnings (or dividend) announcement Stock price adjust to the new public information rapidly but NOT Instantaneously
Stock P move up after good announcement (a) market overreaction **
Stock P reflect the new public information quickly and accurately stock P disproportionately move up [or down] after good [or bad] news
so investors can earn excess return by using Contrarian Strategy
i.e. buy [or sell] stock immediately after bad [or good] news
sell [or buy] stock several months later
extreme loser portfolio outperform (earn 25% more) than the extreme winner pfl
(a) market underreaction**
stock P do not fully incorporate the new information given in unexpected earnings announcement,
so investor can get excess return in SHORT RUN by using Momentum Strategy (i.e. buy good
news stock, sell bad news stock)
Mutual fund manager cannot beat the market Corporate insider (i.e. company’s CEO) use insider information.
76
Evidence against market efficiency

• Some empirical studies have showed the existence of some anomalies
which are inconsistent with the EMH.
T9-pg38
77
77
Small firm effect and weak-form efficiency

• Lo & MacKinlay (1988) found that next period’s returns of small firms’ stocks
have been positively correlated with previous returns even for weekly &
monthly periods (i.e. small firm effect).
• Thus, investor can earn excess returns by forming small stock portfolio.
Explanation of small firm effect:
i) Low liquidity of small firms or inappropriate measurement of risk for small
firm stocks. Investors demand a higher expected return to compensate for
some risk, which is not captured in the beta under the CAPM model.
ii) Data-snooping, superior performance of small-caps is a coincidence.
In USA, the small firm effect is limited to 1970s-1980s
iii) Weak-form market inefficiency; an anomaly that provided investors with
an opportunity to make excess returns over a period of two decades in the
USA. However, very difficult to make profits out of it consistently from the
1990s on.
• No obvious evidence that the return predictability for small stocks implies
weak-form market inefficiency.
78
78
Calendar Effects And Weak-form Efficiency

• Calendar effect represents a pattern in stock returns related to either
the day of the week, the week of the month or the month of the year.
Eg1) January effect - stock returns (particularly for small stocks) are
20093b-ZAB
greater in January than in any other month of the year.
Eg2) Monday effect- lower returns on Monday than in other days of the week,
Eg3) Daily effect - most daily returns at the beginning & end of the day.
T9-pg39
79
79
Calendar effects and weak-form efficiency

January effect 20093b-ZAB
• Buy small stocks at the end of December & sell them at the end of January.
• If all investors follow the January strategy to generate excess returns.
Then all investors would follow. As a result,
prices increase in December (due to higher demand), &
prices decrease in January (due to higher supply).
and excess returns be eliminated.
• The continued existence of the January effect is puzzling.
• Specifically, it is inconsistent with random walk behaviour, and
gives strong indications against weak-form market efficiency.
80
80
Calendar effects and weak-form efficiency

Explanation of January effect: 20093b-ZAB
(i) January effect with the small firms effect: Fama (1991) reported
that during 1941–81, January return was 8.06% (small stocks) &1.342%
(large stocks).
January return was higher than the average return in other months, but
also most of the January effect was associated with small stocks.
However during 1981–91, the difference in January returns
between large & small stocks was less pronounced.
(ii) Taxation impacts (i.e. tax-selling hypothesis).
• Investors sell securities (with substantial losses) before year end
in order to benefit from a tax loss. Only reinvest in the following year.
• Dec securitie sales depress prices; Jan purchase increases price.
• However, we do not observe in financial markets any negative Dec effect
when the tax-loss incentive induces selling the stocks. T9-pg40
81
81
Implications of the fund mangers’ remuneration.

82 20093b-ZAB
• Haugen and Lakonishok (1988) stated that
January/ small firm effect may be caused by portfolio manager having
(i) window dressing or (ii) performance hedging.
Window dressing
• fund managers sell large losses stocks & purchase good performing stocks near
the year end (or quarter end), to improve the fund performance
before presenting it to clients or shareholders. .
Performance hedging
-fund managers are compensated for achieving returns above some benchmark.
• Fund managers sell risky stocks once has reached the benchmark &
buy them again in January (after the bonus has been paid).
• Cheng-few, Porter and Weaver (1998) suggest that the hypothesis of
performance hedging is more likely than window dressing.
Window dressing can reduce investors’ value
(because of the unnecessary transaction costs incurred to discern true
rather than ‘dressed up’ portfolio composition) whereas
performance hedging maximize investors’ value
(because of locking in superior performance). 82
82
Mean reversion and weak-form efficiency

• Mean reversion means that stocks with a
low return today show a high return in the future, & vice versa.
• Stocks perform poorly in the past 3-5 years will do well in the next 3-5 years
(Fama & French,1988; Poterba & Summers, 1988).
• Mean reversion enables investors to predict changes in the future prices.
Therefore, stock prices do not follow a random walk.
This seems to indicate inefficiency in the weak-form.
• However, evidence on mean reversion is NOT conclusive, as some
empirical studies show a diminished importance of the mean reversion
phenomenon after the Second World War.
T9-pg41
83
83

Anomalies: evidence against market efficiency
Anomalies exist which are (consistent/ inconsistent) with the EMH.
Anomalies of weak-form efficiency: (1) Small firm effect (2) Calendar effect
S______ Lo & MacKinlay (1988) found that next period’s returns of small firms’ stocks have
_ been positively correlated with previous returns even for weekly & monthly periods
(i.e. small firm effect). Thus, investor can earn excess returns by forming small
f_______ stock portfolio. Explanation of small firm effect:
_ i) Low liquidity of small firms or inappropriate measurement of risk for small firm stocks. Investors
demand a higher expected return to compensate for some risk, which is not captured in the beta under the CAPM model.
Effect ii) Data-snooping, superior performance of small-caps is a coincidence. In USA, the small firm effect is
limited to 1970s-1980s
iii) Weak-form market inefficiency; an anomaly that provided investors with an opportunity to make excess
returns over a period of two decades in the USA. However, very difficult to make profits out of it consistently from the
1990s on. No obvious evidence that the return predictability for small stocks implies weak-form market inefficiency.
C______ represents a pattern in stock returns related to either the d_________ of the week,
_ effect the w______________ of the month or the m______________ of the year.
J____________ effect - stock returns (particularly for small stocks) are greater in
January than in any other month of the year.
M____________effect- lower returns on Monday than in other days of the week,
D____________ effect - most daily returns at the beginning & end of the day. 84
84
Short Question 2
Discuss the small firm effect, the neglected firm effect, & the January effect, the tax
effect and how the 4 effects may be related.
• Studies have shown that small firms earn a risk‐adjusted rate of return
greater than that of larger firms. Additional studies have shown that firms
that are not followed by analysts (neglected firms) also have a
risk‐adjusted return greater than that of larger firms.
• However, the neglected firms tend to be small firms; thus, the neglected
firm effect may be a manifestation of the small firm effect.
• Finally, studies have shown that returns in January tend to be higher than
in other months of the year. This effect has been shown to persist
consistently over the years.
• However, the January effect may be the tax effect, as investors may
have sold stocks with losses in December for tax purposes and reinvested
in January. Small firms (and neglected firms) would tend to be more
affected by this increased buying than larger firms, as small firms tend to
sell for lower prices.
T9-pg42
85
Short Question 3
With regard to market efficiency, what is meant by the term "anomaly"?
Give 3 examples of market anomalies and
Explain why each is considered to be an anomaly.
• Anomalies are patterns that should not exist if the market is truly efficient.
Investors might be able to make abnormal profits by exploiting the
anomalies, which doesn't make sense in an efficient market.
• Possible examples include, but are not limited to, the following:
 small‐firm effect ‐ average annual returns are consistently higher for
small‐firm portfolios, even when adjusted for risk by using the CAPM.
 January effect ‐ the small‐firm effect occurs virtually entirely in January.
 neglected‐firm effect ‐ small firms tend to be ignored by large
institutional traders and stock analysts. This lack of monitoring makes
them riskier and they earn higher risk‐adjusted returns. The January
effect is largest for neglected firms.
86
 Liquidity effect ‐ investors demand a return premium to invest in

less‐liquid stocks. This is related to the small‐firm effect and the
neglected‐firm effect. These stocks tend to earn high risk‐adjusted rates
of return.
 Book‐to‐market ratios ‐ firms with the higher book‐to‐market‐value
ratios have higher risk‐adjusted returns, suggesting that they are
underpriced. When combined with the firm‐size factor, this ratio explained
returns better than systematic risk as measured by beta.
 Reversal effect ‐ stocks that have performed best in the recent past
seem to underperform the rest of the market in the following periods, and
vice versa. Other studies indicated that this effect might be an illusion.
These studies used portfolios formed mid‐year rather than in December
and considered the liquidity effect.
• Investors should not be able to earn excess returns by taking advantage

of any of these. The market should adjust prices to their proper levels. But
these things have been documented to occur repeatedly.
T9-pg43
87
Exam Focus
35 What is the empirical evidence in favour of and against the2007-4c-ZAB
weak form of market efficiency? (14 marks)
36 Explain weak form efficiency and discuss the empirical evidence in relation2014-7c-ZB
to this form of efficiency. (12 marks)
37 Discuss the evidence relating to weak-form efficiency of equity markets. (12 2018-3c-ZA
38 Describe and discuss the evidence on calendar effects 2009-3b-ZAB
in the context of weak form efficiency.
Refer specifically to the so-called ‘January effect’. (11 marks)
39 Explain the ‘January effect’ in stock markets and 2015-4c-ZA
discuss the evidence for this effect. (10 marks)
88
88
3(b) Describe and discuss the evidence on calendar effects in the context of
weak form efficiency. Refer specifically to the so-called ‘January effect’. (11m)
2009-3b-ZAB
• refer to pp.173–74 of the subject guide and to pp.386–89 (fifth edition)

pp.379–83 (sixth edition) of Mishkin and Eakins, Financial markets and
institutions.Candidates should begin with a clear list of the possible calendar
effects, and then focus on the so-called ‘January effect’, which shows that
stocks returns are greater in January than in any other month of the year.
(Definitions of calendar effect and January effect are awarded 1 mark each.)
• A calendar effect represents a pattern in stock returns related to either
the day of the week, the week of the month or the month of the year.
• Examples of calendar effects are the January effect, the lower returns
on Monday than in other days of the week, and the occurrence of most daily
returns at the beginning and end of the day.
T9-pg44
89
• Candidates should also make clear that the empirical evidence on the January effect is
inconsistent with the random walk behaviour, and gives strong indications against market
weak-form efficiency. (Up to 3 marks were awarded for showing a good understanding of the
January effects, as explained here below.)
• The January effect shows that stock returns (particularly for small stocks) are
greater in January than in any other month of the year. 2009-3b-ZAB
• January effect is inconsistent with random-walk behaviour, and

gives strong indications against market weak-form efficiency.
• The January effect seems to indicate a trading rule: buy small stocks at the
end of December and sell them at the end of January. In this way you will
make a profit. Why is the existence of the January effect problematic?
• Assume that all investors observe such a January strategy generating excess
returns. All investors would follow it. But the consequence would be an
increase in prices at the end of December (because of the increase in demand),
and a decrease at the end of January (due the increase in supply). Therefore
excess returns would tend to be eliminated.
The continued existence of the January effect is puzzling. Specifically, it is
inconsistent with random-walk behaviour, and gives strong indications
against weak-form market efficiency.
90
• Good candidates are then expected to discuss the hypotheses that have
been advanced to explain this effect. These include: 2009-3b-ZAB
(i) Association of the January effect with the small firms effect: as reported
in Fama (1991), over the period 1941–1981, the return experienced in
January was 8.06% for small stocks and 1.342% for large stocks. In both
cases the January return was higher than the average return in other
months, but also most of the January effect was associated with small
stocks. Note however that in recent years – the period 1981–1991 – the
difference in January returns between large and small stocks was less
pronounced.
(Up to 2 marks were awarded to explain the small firm effect. Examiners
would expect an excellent answer to describe the relevant study associated
with the explanation.)
T9-pg45
91
(ii) Taxation impacts (i.e. tax-selling hypothesis). Investors sell securities for which
substantial losses have been incurred before the end of the year, in order to benefit
from a tax loss. Such investors do not invest the proceeds back into the market until
the new year.
The selling in December would depress prices, whereas the purchasing in early
January would generate increases in prices. However, even this explanation does
not seem completely plausible: in fact we do not observe in financial markets any
negative December effect when the tax-loss incentive induce selling the
stocks.(Up to 2 marks were awarded for explaining the taxation effect.) 2009-3b-ZAB
Implications of the remuneration structure of fund managers.
Haugen and Lakonishok (1988) hypothesise that portfolio manager behaviour around
the turn of the year may be a major cause of the January/small-firm effect and that the
effect may result from window dressing or performance hedging. Window dressing can
be value reducing (because of the unnecessary transaction costs necessary to discern
true rather than ‘dressed up’ portfolio composition) whereas performance hedging may
be associated with investor value maximisation (thanks to the possibility to lock in
superior performance). Cheng-few, Porter and Weaver (1998) suggest that the
hypothesis of performance hedging is more likely than the one of window dressing.
(Up to 2 marks were awarded to explain the implications of the remuneration
structure of fund managers. Examiners would expect an excellent answer to describe
the relevant study associated with the explanation.)
92
Part A:
Types of Efficiency
Excess Return
Part B
Empirical evidence in favour of EMH
Empirical evidence against the EMH
- Weak form
- Semi- strong form 93 T9-pg46
93
Market overreaction & semi-strong-form efficiency

• Anomaly related to earnings announcements.
• Empirical evidence confirms rapid adjustment to new information
(see semi-strong-form efficiency).
• However, recent evidence shows that stock prices do NOT instantaneously
adjust due to 2 anomalies: stock price (i) overreaction & (ii) underreaction.
94
94
Market overreaction & semi-strong-form efficiency

(i) Market overreaction
~ prices may disproportionately increase (decrease) due to good (bad)
news announcements, and the pricing error is corrected slowly.
• Empirical evidence by Ball & Brown (1968), Bernard & Thomas (1989)
shows that adjustment to extreme bad news takes several months:
Market overreaction & subsequent gradual adjustment.
[Bernard and Thomas (1989) calculate the Cumulative Abnormal Returns
(CAR) for 10 portfolios with different levels of unexpected good or bad
earnings over the years 1974–86].
• CAR are measured for the pre- & post- announcement period.
Portfolio 10 (contains the 10% of the stocks with the highest earnings),
portfolio 1 (contains the 10% of the stocks with the lowest earnings).
• Portfolio 10 (extreme good news) disproportionately increases its
performance in the days immediately preceding the announcement, and
portfolio 1 (extreme bad news) disproportionately decreases its performance. T9-pg47
95
95
• But in medium-long term after the announcement,

the performance of portfolio 10 decreases &
the performance of portfolio 1 increases.
• It seems that there is an overreaction before the announcement, & then the
market needs subsequent gradual adjustments
to correct the overreaction to the unexpected information.
• Investors could get excess returns by implementing a trading strategy:
to buy (sell) stocks immediately after the announcement of bad (good) news,&
sell (buy) them after several months when the price has risen (fallen) again.
i.e. contrarian strategy (inconsistent with semi-strong-form efficiency).
96
96
• DeBondt & Thaler (1987) indicates that

portfolios composed of extreme ‘losers’ (recently poorly performed stock)
dramatically outperformed
portfolios composed of extreme ‘winners’ (recently well performed stocks).
• In the 36 months after each portfolio formation,
extreme loser portfolios earned 25% more than extreme winner portfolios.
i.e. getting excess returns from a contrarian strategy
(inconsistent with the weak-form efficiency
because the definition of winners & losers is based on historical returns &
not on the release of a new piece of information).
T9-pg48
97
97
Underreaction & semi-strong-form efficiency

(ii) Underreaction to earnings announcements means that
stock prices do not fully incorporate the new information embodied in the
unexpected earnings announcement.
• Bernard and Thomas (1989, p.10),
portfolio 10 outperformed portfolio 1 in the 2 months after the announcement,
& with excess returns difference of +4%.
• Prices of good news stocks continue to rise in the 2 months after the
earnings announcement, whereas prices of bad news stocks continue to fall.
Investors thus can get an excess return in the short term
by buying good news stocks and selling bad news stocks.
i.e. momentum strategy (inconsistent with semi-strong-form efficiency).
98
98
Underreaction & semi-strong-form efficiency

• Jegadeesh & Titman (1993) suggests
buying past winner stocks & selling past losers to get excess returns
(weak-form efficiency market)
• Definition of winners & losers stock is based on historical (NOT new) prices.
• Buy stocks that have increased in price in the recent past and
sell stocks that have performed poorly yields significant excess returns
over 3-12-month holding periods.
• Excess returns associated with a momentum strategy, but this evidence is
inconsistent with the weak-form efficiency (not the semi-strong-form)
because the strategy is based on historical prices only.
• Overreaction & underreaction alternatively characterise the behaviour of
prices in financial markets.
• Empirical evidence of overreaction & underreaction are almost equal. T9-pg49
99
99

Semi-strong-form efficiency: market Overreaction & Underreaction
Anomaly related to earnings announcements. Empirical evidence confirms rapid adjustment to new information. Recent evidence
shows that stock prices do NOT instantaneously adjust due to 2 anomalies. Overreaction & underreaction alternatively
characterise the behaviour of prices in financial markets.Empirical evidence of overreaction & underreaction are almost equal.
(i) prices may disproportionately increase (decrease) due to good (bad) news announcements, and the
pricing error is corrected slowly. Ball & Brown (1968), Bernard & Thomas (1989) shows that adjustment
O________ to extreme bad news takes several months: Market overreaction & subsequent gradual adjustment.It
_ seems that there is an overreaction before the announcement, & then the market needs
subsequent gradual adjustments to correct the overreaction to the unexpected information.
Investors could get excess returns by implementing a trading strategy: to buy (sell) stocks
immediately after the announcement of bad (good) news,& sell (buy) them after several
months when the price has risen (fallen) again.i.e. contrarian strategy (inconsistent with
semi-strong-form efficiency).
(ii) Underreaction to earnings announcements means that stock prices do not fully incorporate
U_________ the new information embodied in the unexpected earnings announcement Bernard and
_ Thomas (1989) Prices of good news stocks continue to rise in the 2 months after the earnings
announcement, whereas prices of bad news stocks continue to fall. Investors thus can get an excess
return in the short term by buying good news stocks and selling bad news stocks. i.e.
m________________ strategy (inconsistent with semi-strong-form efficiency). Jegadeesh & Titman
(1993) suggests buying past winner stocks & selling past losers to get excess returns (weak-form
efficiency market). Buy stocks that have increased in price in the recent past & sell stocks that have
performed poorly yields significant excess returns over 3-12-month holding periods.Excess returns
associated with a momentum strategy, but this evidence is inconsistent with the weak-form efficiency
(not the semi-strong-form) because the strategy is based on historical prices only. 100
100
Exam Focus
40 Discuss the evidence relating to semi-strong efficiency of equity markets. (13 marks) 2016-2c-ZA
41 Discuss the evidence relating to semi-strong efficiency of equity markets. (12 marks) 2018-3c-ZB
42 Discuss the empirical evidence in favour of and against the semi-strong form of 2021-8c-ZB
market efficiency? (14 marks)
43 Discuss the evidence relating to under- and over-reaction to information in equity2016-2c-ZB
markets. (13 marks)
44 Discuss the implications of a market underreaction to new information 2010-8d-ZB
in the context of the EMH (8 marks)
45 Explain the empirical evidence on market underreaction 2009-3a-ZAB
in the context of weak and semi-strong form efficiency. (14 marks)
46 Explain the empirical evidence on market underreaction 2017-4b-ZA
47 Discuss the empirical evidence on market under-reaction 2020-3b-ZA
48 Explain the empirical evidence on market over-reaction 2017-4b-ZB
T9-pg50
49 Discuss the evidence of market overreaction in relation to efficient markets. (10m 2015-4c-Zb
101
101
3(a) Explain the empirical evidence on market overreaction in the

context of weak and semi-strong form efficiency. (14 marks) 20093a
• refer to pp.174–75 of the subject guide. Detailed evidence in Bernard and Thomas ‘Post-earnings announcement drift:
delayed price response or risk premium?’, Journal of accounting research 27 1989, pp.1–36.
• evidence on market overreaction constitutes an anomaly related to

earnings announcements. Although empirical evidence generally confirms
rapid adjustment to new information (as shown in the evidence in favour of
the semi-strong-form efficiency), recent evidence shows that stock prices do
not instantaneously adjust. Two key anomalies are pointed out: stock
price overreaction and underreaction.
• A definition of overreaction should be provided: market overreaction
means that prices may disproportionately increase (decrease) to good (bad)
news announcements, and the pricing error is corrected only slowly.
• the citation of the empirical evidence that shows that
adjustment to extreme bad news takes several months: there is a market
overreaction and subsequent gradual adjustment (see for example the
evidence in Ball and Brown, 1968, then confirmed by Bernard and Thomas,102
102
• The methodology and findings of the study by Bernard and Thomas (1989). They
calculate the Cumulative Abnormal Returns (CAR) for 10 portfolios with
different levels of unexpected good or bad earnings over the years 1974–1986.
CAR are measured for the pre- and post-announcement period.
20093a
• Portfolio 10 contains the 10% of the stocks with the highest earnings
performance, portfolio 1 the lowest 10 per cent. As shown in Bernard and
Thomas (1989), portfolio 10 (extreme good news) disproportionately increases its
performance in the days immediately preceding the announcement, instead
portfolio 1 (extreme bad news) disproportionately decreases its performance.
However, in the medium-long term after the announcement, the performance of
portfolio 10 decreases and the performance of portfolio 1 markedly increases. It
seems that there is an overreaction before the announcement, and then the
market needs subsequent gradual adjustments to correct the reaction to the
unexpected information. As a consequence investors could get excess returns
by implementing a trading strategy: to buy (sell) stocks immediately after the
announcement of bad (good) news, and sell (buy) them after several months
when the price has risen (fallen) again. This trading strategy is known as
contrarian strategy. The possibility of profitably implementing a contrarian
strategy in such a framework is inconsistent with semi-strong-form efficiency. T9-pg51
103
103
• Make the link with the empirical evidence on overreaction existing at a 2009
different level of informational efficiency – the weak form efficiency (see, for
example, DeBondt and Thaler, 1987).
• This evidence indicates that portfolios composed by extreme ‘losers’ (stocks
that have performed poorly in the recent past) dramatically outperformed prior
portfolios formed by extreme ‘winners’ (stocks that have increased in price
in the recent past). In the 36 months after the portfolio formation,
extreme loser portfolios earned 25% more than extreme winner portfolios.
Once again, we have evidence of the possibility of getting excess returns
out of a contrarian strategy. But in this case, such a possibility is
inconsistent with the weak-form efficiency because the definition of
20093a
winners and losers is based on historical returns and not on the release of a
new piece of information.
104
104
3. (a) Explain the empirical evidence on market underreaction in the context of

weak and semi-strong form efficiency. (14 marks) 2009-3a-ZAB
• refer to pp.175–76 of the subject guide. Detailed evidence in Bernard and Thomas
‘Post-earnings announcement drift: delayed price response or risk
premium?’, Journal of accounting research 27 1989, pp.1–36.
• This question relates to the empirical evidence on market underreaction, and
therefore relates to the validity of semi-strong efficiency in stock markets.
• Candidates should begin by stating that evidence on market underreaction
constitutes an anomaly related to earnings announcements.
• Although empirical evidence generally confirms rapid adjustment to new information
(as shown in the evidence in favour of the semi-strong-form efficiency),
recent evidence shows that stock prices do not instantaneously adjust.
• 2 key anomalies are pointed out: stock price overreaction and underreaction.
(1 mark.) A definition of underreaction should be provided:
• underreaction to earnings announcements means that
stock prices do not fully incorporate the new information
embodied in the unexpected earnings announcement. (1 mark. T9-pg52
105
• Candidates are then expected to move to the citation of the empirical evidence that
shows that adjustment to extreme bad news takes several months:
there is a market overreaction & subsequent gradual adjustment (see for
example the evidence in Ball and Brown, 1968, then confirmed by
Bernard and Thomas, 1989). (1 mark for citing the authors.)
• The Examiners then expect the description of the methodology & findings of the
study by Bernard and Thomas (1989).
They calculate the Cumulative Abnormal Returns (CAR) for 10 portfolios with different
levels of unexpected good or bad earnings over the years 1974–1986. CARs are
measured for the pre- & post-announcement period. Portfolio 10 contains the 10% of
the stocks with the highest earnings performance, portfolio 1 the lowest 10%.
Looking at Bernard and Thomas (1989), portfolio 10 outperformed portfolio 1 in the
two months following the announcement, and the difference in the excess returns
has been equal to +4%. Prices of good news stocks continue to rise in the two
months after the earnings announcement, whereas prices of bad news stocks
continue to fall. Investors thus can get an excess return in the short term by buying
good news stocks and selling bad news stocks. Such a trading strategy is known as
momentum strategy. The possibility of profitably implementing a momentum
strategy in such a framework is inconsistent with semi-strong-form efficiency.
106
• Outstanding candidates were expected to make the link with the empirical
evidence on underreaction existing at a different level of informational
efficiency – the weak form efficiency (see results in Jegadeesh and Titman,
1993). This evidence suggests buying past winner stocks and selling past losers
to get excess returns. Here the definition of winners and losers is based on
historical prices and not the release of any new information. To buy stocks that
have increased in price in the recent past and to sell those that have performed
poorly yields significant excess returns over 3- to 12-month holding periods.
Once again this evidence suggests
excess returns associated with a momentum strategy, but this evidence is
inconsistent with the weakform efficiency (not the semi-strong form) because
the strategy is based on historical prices only.
• Candidates should finally note that both overreaction and underreaction
alternatively characterise the behaviour of prices in financial markets, and
empirical evidence provides a roughly equal number of examples of overreaction
and underreaction. (1 mark.)
T9-pg53
107
Corporate insiders and strong-form efficiency

• Corporate insiders (e.g. company’s directors) use insider information
to buy stocks prior to stock price rises & to sell prior to stock price falls.
• Insiders aim to earn excess returns from trading in their own company’s
stocks.
• Insider trades can be used to predict subsequent stock price changes
(inconsistent with strong-form efficiency).
108
108
Summary for Topic 9

• The topic investigated whether stock prices reflect all available information in
financial markets. If the efficient market hypothesis holds, investors are
unable to make excess returns on a certain information set.
• Commonly, three broad observable information sets are used to define
informational efficiency: weak-form, semi-strong-form and strong-form
efficiency.
• The empirical evidence overwhelmingly suggests that financial markets are
weak-form efficient: just refer to the random walk behaviour of stock prices,
and to the uselessness of technical analysis. Nevertheless several important
anomalies have to be taken into account: calendar effects, small size effect,
and long-term mean reversion behaviour of stocks.
• The evidence on semi-strong efficiency is more mixed.
• The rapid incorporation of new and unexpected information is in favour of
semistrong- form efficiency; whereas the phenomena of market overreaction
and underreaction to new information are against it.
• Anyway, the majority of empirical evidence does suggest that prices fully,
accurately and speedily reflect all new public information in most stock
markets. T9-pg54
109
109
Revision Exercise
Topic 9- Topic 9:Financial Markets –Transmission of Information (EMH)
[can be in either Section A or B]
1. Distinguish between informational efficiency, valuation efficiency and
allocative efficiency. (6,8,9,10 marks)
[+Explain why allocative efficiency depends upon the existence of valuation
and informational efficiency]
2. Theoretically derive the efficient market hypothesis.
[=Theoretically derive a framework to analyze whether markets are
informationally efficient. (7,10,10 marks)
3. Discuss why the assumption of informationally efficient markets [T9] is
important for traditional capital budgeting [T7] and portfolio theory &
asset pricing[T8]. (7,9 marks)
110
110
4. What are excess (abnormal) returns in the financial market? Explain how
this could be calculated in the context of testing for informational
efficiency in markets. Explain why in an informationally efficient market
investors are not able to make consistent excess returns. (5,6,6,6,6,7,7,9
marks)
5. Discuss the joint (or dual) hypothesis problem in the context of testing the
efficient markets hypothesis. (4,5,6,6,7,7 marks)
6. Distinguish between the 3 forms/ level of equity market efficiency and its
implications for investors in equity securities. (6667)
7. What is the empirical evidence in favour of and against the weak form of
market efficiency? (12,14 marks)
8. Explain the ‘January effect’ in stock markets and discuss the evidence for
this effect.
[Discuss the evidence on calendar effects in the context of weak form
efficiency (10 marks)
9. Discuss the evidence relating to under-reaction & over-reaction in the
context of weak and semi-strong form efficiency (8,10,13, 13,14,15,15) T9-pg55
111
111
Summary of Empirical Evidence
1) weak-form efficiency
For: random walk behaviour of stock prices, uselessness of technical analysis
Against: presence of calendar effect, small firm effect and mean reversion
2) semi-strong-form efficiency
For: incorporation of earnings-announcement information
Against: market overreaction and underreaction to new information)
3) Strong-form efficiency
For: mutual fund performance
Against: excess return of corporate insiders
112
112
Summary for Topic 9

• Strongform efficiency has received least attention in empirical studies
because intuitively it is more difficult to believe that markets are strongly
efficient and because it is more difficult to get empirical data.
• But despite these difficulties, there is evidence that stock markets may be
efficient in the strong-form (mutual fund performance).
• At the same time, the evidence on corporate insider profits goes against
strong-form efficiency.
• Overall we have seen that it is difficult to get a definitive answer on
informational market efficiency.
• Instead of dichotomised categories of efficient and inefficient financial
markets, it seems more sensible to define different degrees of efficiency, and
classify certain markets (or markets at certain times) as being more efficient
than others.
T9-pg56
113
113
Sample examination questions

1.
a. In what ways does informational efficiency affect capital budgeting and
portfolio theory?
b. What is the theoretical framework for the derivation of the efficient market
hypothesis?
c. What are excess returns? What techniques are used for their calculation?
d. How does the joint hypothesis problem affect the interpretation of results on
efficient markets?
114
114
Sample examination questions

2.
a. Compare and contrast the weak-form, the semi-strong-form and the strong-
form efficiency of financial markets in the test of the efficient market
hypothesis.
b ‘If stock prices follow a random walk, investors can earn excess returns by
using trading rules based on past data’. Is this statement true or false?
Explain your answer.
c What is the empirical evidence against weak-form market efficiency? Illustrate
the phenomena identified by these studies.
d What is the empirical evidence in favour of and against the semi-strong form of
market efficiency?
T9-pg57
115
115
References
• M. Buckle (2011) Principle of Banking and Finance Subject Guide, Chapter 9.

Essential reading
• Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance.
(Boston, London: McGraw-Hill/Irwin, 2010) tenth edition Chapter 13.
• Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 6.
Further Reading
• Copeland, T.E., J.F. Weston and K. Shastri Financial Theory and Corporate
Policy. (Boston, London: Pearson Addison Wesley, 2005) Chapter 10.
• Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio
Theory and Investment Analysis. (New York: John Wiley & Sons, 2007)
Chapter 17.
• Smart, S.B., W.L. Megginson and L.J. Gitman Corporate Finance. (Mason,
Ohio: South-Western/Thomson Learning, 2004) Chapter 10. 116
116
T9-pg58

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Topic 9: Financial markets – Transm ission of Inform ation

Either Section A or B Exam focus + outline

_____________ efficiency ___________Return [5-7m]

[8-15m] Arguments for EMH Arguments against

Outline for Topic 9

3. Efficient Market Hypothesis (EMH)

4. Implications of EMH for weak, semi-strong, strong-form efficiency

Outline for Topic 9

6. Empirical Evidence against market efficiency

• To investigate whether stock prices reflect all available information

Topic 9- Transmission of Information [EMH] Key concept

3 types of Efficiency* [6-9 marks]

Importance of Informational Efficiency

Financial mkt need to reflect the ___________________ correctly

Derive* [7-10 marks]

Concept Check Activity:

2) more specific form of efficiency than valuation efficiency

7. (a) Explain what is meant by informational efficiency, valuation efficiency

Evidence on market efficiency (Fama’s 1970)

Informational Efficient Markets

7(c) Explain why the concept of informational efficiency

• the main objective of capital budgeting (i.e. to maximise shareholder wealth

Informational Efficient Markets

Efficient Market Hypothesis (EMH)

• equation for every financial asset (both bonds and stocks)

Excess Return ** Actual return - Equilibirum return

Stock A vs Stock BCD

have ___________ RETURN]

If RF > E(R*) if RF < E(R*)

Sell =$55 Extra info

Return = 55-30 = 25 [____ return] Return = 55-20 = 35 [______ return]

• If actual return of a stock < return on other securities of equivalent risk

They can only earn normal returns (i.e. equilibrium returns).

a) Excess rate of return on stock ABC is negative (–2%),

Optimal Forecast of Returns

= _______ return – equilibrium _____________return = Rtx = Rt -E(R*t)

4. (a) What are excess (abnormal) returns?

• refer to page 145 of the subject guide.

In an efficient market, no investor can make excess returns

• To describe the pricing behaviour in efficient markets, we can replace E(R)

Joint Hypothesis Problem * [4-7 marks]  EMH is untestable Key concept

•_________ is untestable in the ___________________ mkt portfolio

* _________ does not tell the underlying factor

unknown whether the mkt is efficient or inefficient

Joint Hypothesis Problem

Concept Check Activity:

10(c) Discuss the joint hypothesis problem. (6 marks)

Efficient market Key concept

___________nature of the 3 forms of EMH

3 Forms Stock Price fully reflect Implication

Levels Of Informational Market Efficiency

(1) Weak-form efficiency:

(3) Strong Form Efficiency

(3) Strong-form efficiency:

Concept Check Activity:

S___________ prices reflect all p___________ & ___________information.

7(d) Distinguish between weak-form, semi-strong form and strong-form levels

The three forms are nestedso that if a market is semi-strong efficient, it

Implication 3: Strong-form efficient market

25 Distinguish between weak-form, semi-strong form and strong-2010-8a-ZB

3(a) Distinguish between weak-form, semi-strong form and strong-form

SEMI-STRONG FORM SEMI-STRONG FORM

Empirical Evidence to Support EMH Empirical Evidence Not to Support EMH

___ efficiency _Return [5-7m]

If RF > E(R) if RF < E(R)

Return = 55-30 = 25 [ return] Return = 55-20 = 35 [__ return]

= _ return – equilibrium _______return = Rtx = Rt -E(R*t)

•_ is untestable in the ___________ mkt portfolio

S_____ prices reflect all p_ & _______information.