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International Financial
Markets and Banking
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Juliane Thamm

SW 3.07, Ext.: 3889, juliane.thamm@strath.ac.uk

Office hours: see myplace for details and/or email for an appointment
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S T R AT H C LY D E B U S I N E S S S C H O O L

Lecture 7
Market Efficiency

© Juliane Thamm – University of Strathclyde

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Roles of the Financial System

S T R AT H C LY D E B U S I N E S S S C H O O L

Providing the payment system for the economy

(Cash dispensers, cheque clearing, credit cards, etc)

Financial intermediation between surplus and deficit units in the

economy

Raising capital for business through primary capital markets

Allowing investors to adjust their portfolios through secondary capital

markets
© Juliane Thamm – University of Strathclyde
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Market Efficiency
S T R AT H C LY D E B U S I N E S S S C H O O L

There are three different types of efficiency:

Operational Efficiency
Do the financial markets operate at an appropriate cost?

Informational Efficiency
Do market prices reflect all available information in an appropriate manner?
A further distinction is between strong, semi-strong and weak form efficiency

Allocative Efficiency
Does the financial system provide capital to the appropriate sectors of the economy?
© Juliane Thamm – University of Strathclyde
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Operational Efficiency
S T R AT H C LY D E B U S I N E S S S C H O O L

London is a major international centre for capital market business which suggests the markets
here are operationally efficient

Big Bang swept away many restrictive practices and institutions now compete for business
which is likely to keep costs low.
There are no exchange controls in the UK meaning capital is free to leave the country. The fact
that much of it stays here suggests London’s markets have advantages over other countries

Other parts of the financial system, such as retail banking, have been opened up to competition
in recent years and are likely to have become more competitive as a result. However, the
starting point may not have been a very favourable one.

The UK has comprehensive financial regulation.

That may be a good thing or a bad thing from an efficiency point of view depending on the
nature of the regulation (see later slides)

© Juliane Thamm – University of Strathclyde

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Informational Efficiency
S T R AT H C LY D E B U S I N E S S S C H O O L

According to Fama (1970), there are three different forms of informational efficiency:
Weak-form efficiency
It is not possible to predict future share price movements using information about past
price changes

Semi-strong-form efficiency
It is not possible to predict future share price movements using any publicly available
information (e.g. from published company accounts)

Strong-form efficiency
It is not possible to predict future share price movements using any information
whether public or private (e.g. information known only to company insiders)
© Juliane Thamm – University of Strathclyde
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621x414/LiveMint/Period1/2013/10/22/Photos/Nobelprize1--621x414.jpg

Background
S T R AT H C LY D E B U S I N E S S S C H O O L

The idea of market efficiency relies on assumptions about how investors behave

When information becomes available, market participants (investors) analyse it -

hoping to profit

This competition assures prices reflect new information quickly and accurately

Investors are assumed to be “rational”:

Maximise expected wealth or utility
Have consistent preferences
Are not fooled by how information is presented

An extreme version of market efficiency requires everyone to behave like this

A more reasonable version assumes there are enough smart arbitrageurs to exploit
any pricing anomalies that occur and keep markets efficient
© Juliane Thamm – University of Strathclyde
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Weak Form EMH

S T R AT H C LY D E B U S I N E S S S C H O O L

Idea: Stock prices reflect all of the information contained in past stock prices, i.e. their
own history

Implications: You cannot consistently profit by spotting trends and patterns in stock
prices.

The fact that a stock has been rising recently is not a reliable indication that it will
continue to do so.

Technical analysis - the study of stock charts for patterns - will not produce superior
returns on a consistent basis

© Juliane Thamm – University of Strathclyde

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Semi-strong Form EMH

S T R AT H C LY D E B U S I N E S S S C H O O L

Idea: Stock prices reflect all of publicly available information (including company
accounts, industry data etc.)

Implications: You cannot consistently profit by analysing company accounts and other
public data.

If public data suggests a company is doing well this is likely to already be reflected in the
(high) stock price

Fundamental analysis - the study of financial ratios and company prospects - will not
produce superior returns on a consistent basis

The market will also be weak-form efficient since past stock prices are part of the set of
publicly available data

© Juliane Thamm – University of Strathclyde

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Strong Form EMH

S T R AT H C LY D E B U S I N E S S S C H O O L

Idea: Stock prices reflect all information (including information known only to company
insiders.)

Implications: No-one can earn excess returns by stock picking, not even people with
inside information.

If a company is doing well this is likely to already be reflected in the (high) stock price

The market will also be weak-form efficient since past stock prices are part of the set of
information

The market will also be semi-strong form efficient since publicly available data is part
of the set of information

© Juliane Thamm – University of Strathclyde

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Beating the Market???

S T R AT H C LY D E B U S I N E S S S C H O O L

What does an investor need to outperform the market on a consistent basis?

To have relevant information other participants do not have (informational advantage)

and / or

Be able to assess available information more quickly and accurately than other
participants

In both cases, for the investor to outperform on a consistent basis, the advantages
have to be ongoing
As Bodie, Kane and Marcus (2008) note, “it makes sense to consider and respect your
competition”

© Juliane Thamm – University of Strathclyde

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Implications of Market Efficiency

S T R AT H C LY D E B U S I N E S S S C H O O L

“Active management” – attempting to beat the market through stock selection and
timing

“Passive management” – buy and hold

Proponents of the EMH believe active management is a costly waste of time

(although see Grossman/Stiglitz on next page)

Many firms offer “Index Funds” to enable investors to buy and hold a broad portfolio
of shares.
Index funds typically have lower fees than active funds

© Juliane Thamm – University of Strathclyde

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Incremental Performance
S T R AT H C LY D E B U S I N E S S S C H O O L

We know that professional investors devote a lot of resources to researching stocks

Does the EMH mean this money is wasted?

Grossman and Stiglitz (1980)* note that in a competitive environment research effort
should generate enough incremental return to cover the cost of doing it, but is unlikely
to generate excess returns consistently after costs

This is an application of the usual economic idea that competitive forces erode the
opportunity for excess profits

*Grossman, Sanford J. and Stiglitz, Joseph E. “On the Impossibility of Informationally Efficient Markets.” American Economic Review, 1980, 70, pp. 393-408.

© Juliane Thamm – University of Strathclyde

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S T R AT H C LY D E B U S I N E S S S C H O O L

What market efficiency does not imply..

An efficient market does not imply that

(a) stock prices cannot deviate from true value; in fact, there can be large deviations from
true value. The deviations do have to be random.

(b) no investor will 'beat' the market in any time period. To the contrary, approximately half of
all investors, prior to transactions costs, should beat the market in any period.

(c) no group of investors will beat the market in the long term. Given the number of
investors in financial markets, the laws of probability would suggest that a fairly large number
are going to beat the market consistently over long periods, not because of their investment
strategies but because they are lucky.

In an efficient market, the expected returns from any investment will be consistent with the
risk of that investment over the long term, though there may be deviations from these expected
returns in the short term.
© Juliane Thamm – University of Strathclyde
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Testing Market Efficiency

S T R AT H C LY D E B U S I N E S S S C H O O L

Tests of market efficiency look at the whether specific investment strategies earn
excess returns. Some tests also account for transactions costs and execution
feasibility. In every case, a test of market efficiency is a joint test of market
efficiency and the efficacy of the model used for expected returns.

When there is evidence of excess returns in a test of market efficiency, it can indicate
that markets are inefficient or that the model used to compute expected returns
is wrong or both.

There are a number of different ways of testing for market efficiency, and the approach
used will depend in great part on the investment scheme being tested.

© Juliane Thamm – University of Strathclyde

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Image this slide is: Fig 1. Cross-sectional variation in market integration and
S T R AT H C LY D E B U S I N E S S S C H O O L

informational efficiency (sample period 1995–2007 )

Source:
Hooy, C-W., and K-P. Lim (2013) ‘Is market integration associated with informational efficiency of stock
markets?’, Journal of Policy Modelling 35(1), pp. 29–44.

Images on next two slides:

http://www.overcomingbias.com/wp-content/uploads/2012/10/stock-market-cartoon1-1bmisqv.png

https://image.slidesharecdn.com/economicefficiency-160107210705/95/economic-efficiency-4-
638.jpg?cb=1452200896

© Juliane Thamm – University of Strathclyde

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Allocative Efficiency
S T R AT H C LY D E B U S I N E S S S C H O O L

Do the financial markets produce the correct signals as to the best use of capital in the
economy?

It is often argued that investors in UK markets are too “short term” and not prepared to
invest in worthwhile projects with longer term payoffs (e.g. Research & Development)

Governments at various points have sought to remedy this perceived problem

For example, in 2000 the government asked Paul Myners – a fund management
executive – to investigate why pension funds don’t invest more in private equity (i.e.
start up capital for new business). His report was fairly inconclusive on that score.*

On balance, it is difficult to be confident that short-termism is indeed a problem and,

perhaps, harder to identify a sensible solution if it is
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S T R AT H C LY D E B U S I N E S S S C H O O L

The Treasury's report "Institutional Investment in the United Kingdom: A

Review" (the Myners Review) suggested in 2001 that various sectors of the
UK equity market may be suitable for active investment management, tacitly
assuming that some sectors are efficient whilst others are not.*

Willcocks (2006) tests the validity of this assumption against 29 industrial

sector indices within the FTSE All Share index. Only one sector, Personal Care
& Household Products, is found where there is scope for active management
to make an abnormal gain in excess of costs. Thus the Myners review's
suggestion of active management where appropriate was valid, but limited
solely to this one sector.**

* Further optional information at: https://www.icaew.com/technical/corporate-governance/codes-and-reports/myners-report (follow up report:

https://www.plsa.co.uk/portals/0/Documents/0051_Institutional_investment_in_the_UK_six_years_on_report_and_recommendations_1107.pdf )

** https://eprints.bournemouth.ac.uk/10549/1/Willcocks%2CGeoffrey_Ph.D._2006.pdf
© Juliane Thamm – University of Strathclyde
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Feedback loop
S T R AT H C LY D E B U S I N E S S S C H O O L

feedback loop between security prices on secondary markets and real

investment, see e.g. Dow & Gorton (1997)*, or Polk & Sapienza (2009)**
security prices convey useful information about investment opportunities.
In this sense informational efficiency of markets is linked to allocative
efficiency of markets.
wrong signals due to informationally inefficient markets are a problem,
because the market might then provide the wrong goods for the wrong
people at a wrong price

* https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.1997.tb02726.x
** https://www.kellogg.northwestern.edu/faculty/sapienza/htm/polk-sapienza.pdf

© Juliane Thamm – University of Strathclyde

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Selected recent research:

S T R AT H C LY D E B U S I N E S S S C H O O L

Kahraman, B., and S. Pachare (2017) ‘Show Us Your Shorts?’ , University of Oxford - Said
Business School working paper. Available at: https://editorialexpress.com/cgi-
bin/conference/download.cgi?db_name=AFA2018&paper_id=237

What is the impact of higher publicity in the shorting market on informational efficiency? To answer this, we exploit
amendments to rules in the U.S. markets which increased the frequency of public dissemination of short-sales from once-a-
month to twice-a-month. Theoretically, higher publicity can improve or deteriorate informational efficiency. We find that, with
more frequent disclosure, short-sellers’ information is incorporated into prices faster, improving informational
efficiency. Efficiency gains are pronounced for stocks with negative information and poor informational environments.
Consistent with our main findings, we document important market reactions to short-sales announcements, and reductions
in short-sellers’ horizon risk and holding periods.

© Juliane Thamm – University of Strathclyde

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S T R AT H C LY D E B U S I N E S S S C H O O L

Robinson, C.J. (2016) ‘Stock Price Behaviour in Emerging Markets: Tests for Weak-Form
Efficiency on the Jamaica Stock Exchange’, University of West Indies, Cave Hill, working paper.
Available at: http://ssrn.com/abstract=2845446

This paper conducts a number of statistical tests to investigate the weak form efficiency of the Jamaica Stock Exchange
(JSE). In contrast to previous studies on the efficiency of the JSE, the paper analyses the efficiency of all listed stocks, as
opposed to the market index. The paper is also the first to explore seasonal patterns on the JSE. An analysis of daily returns
on all stocks listed on the JSE over the period January 2, 1992 to December 31, 2001 rejects the hypothesis of randomness
in the rates of return series for the majority of stocks listed

© Juliane Thamm – University of Strathclyde

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Urquhart, A. (2016) ‘The Inefficiency of Bitcoin’, Southampton Business School working paper.
S T R AT H C LY D E B U S I N E S S S C H O O L

Available at: http://ssrn.com/abstract=2828745

Bitcoin has received much attention in the media and by investors in recent years, although there remains scepticism and a lack of
understanding of this cryptocurrency. We add to the literature on Bitcoin by studying the market efficiency of Bitcoin. Through a
battery of robust tests, evidence reveals that returns are significantly inefficient over our full sample, but when we split our sample
into two subsample periods, we find that some tests indicate that Bitcoin is efficient in the latter period. Therefore we conclude that
Bitcoin in an inefficient market but may be in the process of moving towards an efficient market.

Cao, C., Liang, B., Lo, A.W., and L. Petrasek (2016) ‘Hedge Fund Holdings and Stock Market
Efficiency’, Pennsylvania State University working paper. Available at: http://ssrn.com/abstract=2793513

We examine the relation between changes in hedge fund equity holdings and measures of informational efficiency of stock prices
derived from intraday transactions as well as daily data. On average, hedge fund ownership of stocks leads to greater improvements
in price efficiency than mutual fund or bank ownership. However, stocks held by hedge funds experienced extreme declines in price
efficiency during liquidity crises, most notably in the last quarter of 2008, and the declines were more severe in stocks held by hedge
funds connected to Lehman Brothers as a prime broker and hedge funds using leverage.

© Juliane Thamm – University of Strathclyde

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Further information
S T R AT H C LY D E B U S I N E S S S C H O O L

Fama, E.F. (1970) ‘Efficient Capital Markets: A Review of Theory and Empirical
Work’, Journal of Finance 25(2), pp. 383-417.
Fama, E.F. (1991) ‘Efficient Capital Markets II’, Journal of Finance 46(5), pp.
1575-1617.

Sewell (2011) History of the Efficient Market Hypothesis

http://www.cs.ucl.ac.uk/fileadmin/UCL-CS/images/Research_Student_Information/RN_11_04.pdf

Bauer, G.H. (2004) ‘A Taxonomy of Market Efficiency’, Bank of Canada

Financial System Review, pp. 37-40. Available at: http://www.bankofcanada.ca/wp-
content/uploads/2012/01/fsr-1204-bauer.pdf
© Juliane Thamm – University of Strathclyde
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S T R AT H C LY D E B U S I N E S S S C H O O L

next steps
Please review the lecture 7 material and complete the week 7 required
reading, then attempt to answer the workshop 7 questions.

Try self-assessment quiz 7 and don’t forget about the Survey home work
and check out podcase 3.

Keep e-mailing topic suggestions for future Tuesdays.

… and attend the next session!

© Juliane Thamm – University of Strathclyde
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S T R AT H C LY D E B U S I N E S S S C H O O L

further help:

Come to any office hours – these are drop-in sessions, no appointment

needed! All details are on the AG991 myplace page.

Send any questions you may have by e-mail.

If you wish to see me outside of office hours, please e-mail to make

arrangements.
© Juliane Thamm – University of Strathclyde
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