Chapter 8

The Efficient Market

Hypothesis
 Efficient Market Hypothesis
(EMH)
 Do security prices reflect relevant information
fully and immediately?
– What kind of information?
• Past prices, trading volume, etc  Weak form EMH

• Public information announced  Semi-strong EMH

• Private information of managers  Strong EMH

– Competition assures prices to reflect information

• Once information becomes available, market

participants analyze it and trade on it

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What are the implications of the EMH?
 Implications for investment
– Will it be possible to beat the market consistently over time?
• In efficient markets, technical trading rules should not work

since all of the past information is contained in current prices

– Empirical evidence is mixed
• Evidence of overreaction or underreaction to information, etc.

 Do stock prices follow random walk?

– Stronger assumption than the EMH
– In fact, EMH allows a submartingale process
• Expected price is increasing over time

• Positive trend and random about the trend

 Implications for corporate finance and business

– Should be difficult to find a project with positive NPVs
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Security Random Walk with Positive Trend
Prices

Time 4
Implications for Active or Passive
Management
 Active Management
– Security analysis
• Technical analysis  Market timing

• Fundamental analysis  Stock selection

 Passive Management
– Buy and Hold
– Index Funds
 Empirical evidence
– Investing in passively managed funds such as index fund has
outperformed actively managed funds for the last several
decades.
– What does this imply?
• It is difficult to beat the market consistently over time
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 EMH and Competition

 Stock prices fully and accurately reflect publicly

available information
 Once information becomes available, market
participants analyze it
 Competition assures prices reflect information

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Then, do we need portfolio managers
in an efficient market?
 Even if the market is efficient, there exists a
role for portfolio managers
– Find an optimal portfolio on the efficient frontier
• Two-fund separation theorem

– Maintain appropriate risk level

– Tax considerations

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 Types of Security Analysis
 Technical Analysis
– Use prices and volume information to predict future prices
– Mainly for market timing purpose
– Related to the weak form efficiency
 Fundamental Analysis
– Use economic and accounting information to predict stock prices
– Mainly for stock selection purpose
– Related to the semi-strong form efficiency
– This includes
• Economic Analysis

• Industry Analysis

• Security Analysis

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 Empirical Tests of Market
Efficiency
 Weak form efficiency
– Test profitability of some trading rules to see whether past price
or volume contains useful information
 Semi-strong form efficiency
– Perform event studies around important announcements to see
whether public information is reflected immediately
 Strong form efficiency
– Assess performance of professional managers or insiders to see
whether they have superior information unknown to public
investors

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 How Tests Are Structured
 Examine prices and returns over time
– Serial correlation?
– Seasonality?
– Any predictability?
 Calculate abnormal returns around event windows
– Using the market model, estimate the following:
a. Rt = at + btRmt + et
 Expected Return = at + btRmt
 Excess Return = Actual – Expected return
= (at + btRmt + et) – (at + btRmt) = et
b. Cumulate the excess returns over event windows 10
 Abnormal returns around the Event

-t 0 +t
Announcement Date

Cumulative Abnormal Returns around the Event

-t 0 +t 11
 Tests of Weak Form EMH
 Returns over short horizons
– Very short horizons (over a couple of weeks)
• Small magnitude of positive trends and reversals

– 3~12 months
• Some evidence of positive momentum

 Returns over long horizons (over 3~5 years)

– Pronounced negative correlation, i.e., reversals

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 Monthly abnormal returns on
momentum portfolios
 Possible explanations?
– Time-varying risk premium vs. market inefficiency?
– Industry effect?
– Under-reaction to information? (behavioral finance)

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Cumulative monthly returns on momentum
 Increase up to one-year after the portfolio formation,
and then, reverse thereafter.
16

14
.
Cumulative monthly returns (%)

12

10

0
1 6 11 16 21 26 31 36 41 46 51 56
14
Event Months since portfolio formation (6- month/ 6- month momentum strategy)
Tests of Semi-strong Form EMH

 Small Firm Effect (January Effect)

 Book-to-Market ratios
 Earnings-to-price ratios
 Cash flow-to-price ratios
 Dividend-to-price ratios
 Post-Earnings Announcement Drift

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 Size effect (Small firm effect)
 Why does the small firm effect concentrate in
January?

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 Book-to-market effect
 Value vs. Growth stocks – Value premium?
 Fama-French 3-factor model – MKT, SMB, HML

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 Post-Earnings Announcement Drift
 Under-reaction to earnings announcements?

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Cumulative excess returns around stock split
 Does the stock split add value to the firm?
– Information leakage prior to the event

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 Tests of Strong Form EMH:
Professional Manager Performance
 Some evidence of persistent positive and
negative performance of mutual funds
 Potential measurement problems
– Performance depends on investment style, e.g.,
momentum, value strategies, etc.
– Could be compensation for risk
 Superstar phenomenon
– Only a small portion survives

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 Implications of Test Results

 Risk premiums or market inefficiencies

– More relevant question is
“How efficient is the market?”
 True anomalies or data mining
 Behavioral Interpretation
– Inefficiencies exist
– Caused by human behavior

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 Behavioral Possibilities
 Forecasting Errors
 Overconfidence
 Regret avoidance
 Loss aversion (disposition effect)

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