1. Informational Efficiency - market capacity to generate prices that instantly reflect all available relevant information 2. Allocative Efficiency - market capacity to allocate the capital starting from the most profitable to the less profitable investment projects 3. Operational Efficiency - market capacity to minimize the cost of capital rising (transaction costs) 1
Basic Finance Market Efficiency
Informational Efficiency - assertion of EMH (efficient-market
hypothesis) References: *Bachelier, Louis; Mark Davis, Alison Etheridge - Louis Bacheliers Theory of Speculation: The Origins of Modern Finance, Princeton University Press , 2006, pp. 116-182. *Fama, Eugene Efficient Capital Market: A Review of Theory and Empirical Work, Journal of Finance, 25 May 1970, pp. 34-105. *Dragota, Victor; Mitrica, Eugen,. Emergent capital markets' efficiency: The case of Romania, European Journal of Operational Research, Elsevier, vol. 155(2), June 2004, pp. 353-360. 2
Basic Finance Market Efficiency
EMH theory: prices of securities traded already reflect all known
information
Impossibility to consistently (overperform the market*) by using
any known information (*)Investor return > market index return
Basic Finance Market Efficiency
Main features of the informational efficient market:
1. Unpredictable return - market operators (investors/hedgers/speculators) are unable to predict the future periods of abnormal return, positive and /or negative, neither to predict the securities that will have such abnormal returns. - abnormal return = any significant difference between current and expected return - expected return = return resulted from any valuation model (return of buy and hold investment strategy) 4
Basic Finance Market Efficiency
2. Funds are allocated to similar risky investments based on the rule of
profit maximization => proportional risk premiums for securities specific (unsystematic) risk 3. No investors can reach abnormal systematic earnings (return of managers of investment funds = market return <=> no systematic abnormal (excess) return over the market return or over the return of a buy and hold investment strategy) => real expected return for securities = equilibrium expected return 5
Basic Finance Market Efficiency
5.2. Levels of Informational Efficiency
Three levels of information (from the less to the most inclusive) (Fama (1970)): - historical information - public information, including historical information - public and private information
1. Historical information - past price movement (implicitly reflects the
securities history) 2. Public information - all publicly available information (including historical information) Examples: issuing companys financial statements; budgets; announcements (mergers/joint ventures/liquidations); information about the macroeconomic environment; etc 3. Private information - privileged information, usually only available for companies insiders (directors; middle management; other personnel) 6
Basic Finance Market Efficiency
Three forms of informational efficiency:
I. Weak form - current prices of securities fully and instantly reflect all securitys past price history => impossibility to make consistent and/or systematic excess gains by trading securities based on the study of their price movement history There is no theoretical basis for the technical analysis / chartist theory - forecasting of market prices by the means of analysis of data generated by the process of trading *Although, in case of market crises weak efficient market can react inefficient => technical analysis becomes useful 7
Basic Finance Market Efficiency
II. Semi-strong form - current prices of securities fully and instantly
reflect all publicly available information => impossibility to make consistent and/or systematic excess gains by trading securities based on any new publicly available information (including price history) * Fundamental analysis (method of security valuation which involves examining the company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products and competition) is useless 8
Basic Finance Market Efficiency
III. Strong form (theoretical existence) - prices of securities fully and
instantly reflect all information, public and private => impossibility to make to make consistent excess gains by trading securities based on any information, public and private (privileged inside information) *Insiders and their related parties (relatives) are unable to make excess gains (unrealistic but partly implemented by capital market rules) - insiders and their first grade relatives are prohibited to trade securities based on privileged information - any excess gain made by the insiders or their first grade relatives is deeply investigated by capital market authorities 9
Basic Finance Market Efficiency
5.3. Formal model of informational efficiency
- Fair game model: nobody is able to make excess gain -Random walk (RW): the best forecasts of the next period securities prices = current prices Rk,t+1 = E(Rk,t+1|It) + i,t+1 = Rk,t + k,t+1; Rk,t+1 = the actual return on security k in period t+1 (neglecting the dividend yield) E(Rk,t+1|It) = the expected return on security k in period t+1, given the available information at time t (It); k,t+1 = the forecast error, that is the difference between the actual return in the next period (t+1) and the expected return at time t
Randomness of errors comes from their properties:
average of errors = 0 (positive and negative errors compensate each other) errors should not be autocorrelated (current error of forecasting the return should not be correlated with the prior errors) error should be also independent of security return ( error and return variables should be uncorrelated) 10
Basic Finance Market Efficiency
New scientific approaches:
-fractal theory (explains the price evolution splitting it in similar movement periods ) -neural network theory (the market prices evolve like self-learning systems)
7.4. Testing the informational efficiency
Weak informational efficient market => technical analysis is for the most time useless Semi-strong informational efficient market => fundamental analysis is for the most time useless *Most theoretical models assume the efficiency of financial market (at least in its weak form)
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Basic Finance Market Efficiency
Testing weak informational efficiency
(evaluate whether it is possible to make excess profits over the normal profits associated to securities systematic risks) A. Correlation between current and past returns (autocorrelation) B. Filter rules A1. Chart study (chart of points cloud) - points (Rk t; Rk t+1) are drawn in the chart with the origin in the average of the return series (Example: Daily Return autocorrelation for ATBE security, traded at the BSE (1998-2000) Source: Victor Dragot; Eugen Mitric Romanian Capital Market Testing Efficiency www.science.mii.lt/EWGFM-28/straip.htm)
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Basic Finance Market Efficiency
A2. Statistical tests
- autocorrelation coefficient (current and future daily return) (Rt,Rt+1) [-1; 1] - complex statistical tests (random walk price movement): Augmented Dickey Fuller test (ADF); Phillips-Perron test (P-P) B. Filter rules (empirical test) *This test simulates trading based on price history and a trading rule that stipulates selling or buying in case of price variation over a limit, selected by the investor. This limit is usually a certain percent ( %), considered significant for a tendency reverse. If such a simulated trading strategy generates significant excess return over the return of a buy and hold investment strategy, after deduction of the brokerage fees, this is a sign of markets informational inefficiency 13
- study of the market evolution before and after an event that generates public information related to a security (mergers, acquisitions, any splitting, releases of financial statements and any other company announcements) - the tests evaluate if the securities prices behave like a speculative bubble before and after an event (sign of semi-strong informational inefficiency) * chart study only indicative **developed statistical tests designed to quantify the abnormal returns, compared with returns resulted from different pricing models (for example, CAPM) 14
Basic Finance Market Efficiency
Testing the strong informational efficiency (empirical performance
tests) -study of (abnormal) returns made by investment / mutual fund by trading in the capital market compared with different benchmarks returns resulted under different pricing models -lack of significant abnormal returns => strong informational efficiency * Developed markets are not strongly informational efficient ** In case of crisis even other forms of informational efficiency are unfulfilled ***January effect and Week-end effect - temporarily lack of the weak efficiency 15