Presentation on

Efficient Market Theory

Presented By:
Hitesh Punjabi

such as Warren Buffett have consistently beaten the market over long periods of time. • Whether markets are efficient has been extensively researched and remains controversial Definition of Efficient Market Hypothesis – EMH • Efficient market hypothesis (EMH) is an idea partly developed in the 1960s by Eugene Fama. while academics point to a large body of evidence in support of EMH. an equal amount of dissension also exists. and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. the current prices of securities reflect all relevant information. such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day. making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. it should be impossible to outperform the overall market through expert stock selection or market timing. For example. which by definition is impossible according to the EMH. • Detractors of the EMH also point to events. Efficient Market Theory • Do security prices reflect information ? – An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and. • EMH is highly controversial and often disputed. investors. • An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. . as evidence that stock prices can seriously deviate from their fair values. As such. stocks always trade at their fair value on stock exchanges. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis • Meanwhile. • According to the EMH. therefore.

. Classification of Efficient Market Hypothesis The three classification of efficiency as set out by Fama are: 1) Weak form of efficiency. which absorbs all publicly available information 3) Strong Form of efficiency which absorbs all publicly and privately held information This Hypothesis postulates that the market is efficient under free market conditions and it absorbs all the information through demand and supply forces. 2) Semi-Strong form of efficiency. This absorption is of different degrees. which absorbs only past price and volume data and those in returns of the market.

The reason is that as soon as such information is publicly available. • The absorption even if it is incomplete or incorrect. Even if the market absorption is imperfect it will not be possible for the analyst to obtain superior returns on consistent basis. Classification of Efficient Market Hypothesis Weak Form • The weak form states that the current market prices of shares already reflect all the available information that is contained in the historical sequence of prices. it is absorbed and reflected in stock prices. • This implies that past rates of return and other market data should have no relationship with future rates of return • This hypothesis contradicts the statements of Technical Analysts. policy statements on dividends. it will not continue for long and it will not place in same fashion and in a consistent manner. • This weak form of efficient market hypothesis holds that all historical and past information is absorbed in the market forces • They hold that prices move in random fashion. who state historical price movements can help the forecast the future price trends and the prices move in a predictable manner. the results are not predictable and analyst cannot take advantage of the fundamentals and information on them. Independent of the past and hence there is no benefit in examining the past prices. rights. bonds and other corporate information will not yield consistent superior returns to analyst. to gain superior investment returns . Semi-Strong Form • The Semi-Strong form of the efficient market hypothesis postulates that current prices of stocks not only reflect all the information contained in the historical prices but also reflects all publicly available knowledge about the companies. • To Analyse public information on corporate reports. • There can be over adjustments and under adjustments and in the absence of any consistency.

• According to theory security’s intrinsic values change and market prices move randomly around these intrinsic values. or inside can be used to consistently earn superior investment returns by the analyst. Random Walk Hypothesis • Several studies address the issue of whether stock price behavior is a random walk or not. published and present or insider information. There may be upward or downward movements and changes take place in a random manner. because market absorbs all the information by itself. . • To Counter the above arguments it is stated that mutual funds with their better and inside information gain more and earn superior returns. Besides Brokers and sub-brokers who are in the trading. • this Theory thus states that security prices move randomly in a continuous fashion to set new equilibriums. Classification of Efficient Market Hypothesis Strong Form • The strong form of efficient market hypothesis remains that not only is publicly available information useless to the investor but all information is useless to gain superior investment returns. can have inside information and can gain excess profits and empherical tests have proved the same. This new information will force the analyst to re estimate the intrinsic value and again the stock prices move randomly around the new intrinsic value. • This means that no information. The new information affecting the market arrives at random intervals. • The random walk hypothesis simply states that at a given point in time. • This assumes perfect markets in which all information is cost-free and available to everyone at the same time • The market absorbs efficiently all information whether past. be it public. the size(quantum) and direction of the next price change is random with respect to the knowledge available at that point in time. Robert (1959) and Osborne (1959) found that stock price movement follows a random walk. private.

Such absorption leads to quick and prompt movements in prices which are random in fashion.Random Walk Assumptions This theory is based on following Assumptions 1) Market is perfect and free without trade restrictions 2) Market absorbs all the information quickly and efficiently 3) Information is free and costless and is quickly available to all at the same time 4) Information is unbiased and correct 5) Market Players can analyse the information quickly and the information is absorbed in the market through buy and sell signals 6) Demand and supply pressures are absorbed in the market through price changes. .

• Numerous serial correlation studies. • Initial Studies have failed to discover any significant serial correlations. filter rules should not outperform a simple buy-and- hold strategy.correlations). the price changes are considered to be serially independent. Is the price changes in one period correlated with the price change in some other period? • if such auto correlation are negligible. filter rule test. employing different stocks. Serial correlation tests • One way to test for randomness in stock prices changes is to look at their serial correlations (also called auto. Filter Rule Test • An n percent filter rule may be defined as follows:” if the price of a stock increases by at least n percent. • Many Studies have been conducted employing different stocks and different filter rules. sell it • If the behavior of stock prices changes is random. By and large. have been conducted to detect serial correlations. Run tests etc. different time-lags and different time- periods. buy and Hold it until its price decreases by at least n percent from subsequent high. . When the price decreases by at least n percent or more. Weak-form of market efficiency Test: • There have been three major methods to test the dependence of return on time (Weak-form of market efficiency): serial correlation tests. they suggest that filter rules do not outperform a simple buy-and hold strategy. Subsequent studies discovered minor positive correlations.

-----------2 ++--------------3 -. •For example in the above series of plus and minuses. Weak-form of market efficiency Test: Run Test Given a series of stock price changes. for example. each price change is designated a a Plus(+) if it represents an increase or a minus (-) if it represents a decrease.---------------4 +--------------5 • To test series of price changes for independence. the number of runs in that series is compared to see whether it is statically different from the number of runs in a purely random series of the same size. . When the sign of change differs. The resulting series . • By and large the results of these studies seem to strongly support the random walk model. there are five runs as follows ++------------1 . the run ends and new run begins. may look as follows: ++-++--+ •A run occurs when there is no difference between the sign of two changes.

Strong Market efficiency Test To test semi.:- the excess returns is calculated by making adjustments for market performance and risk.strong market efficiency. empirical studies have been conducted hat have examined the following questions •Is it possible to earn superior risk-adjusted returns by trading on information events like earnings announcements. The key steps involved in an event study are as follows 1)Identify the event to be studied and pin point the date on which the event was announced 2)Collect returns data around the announcement date 3)Calculate the excess returns. around the announcement date for each firm in the sample. by the period. R MT is the excess returns on the market for period t 4) Compute the average and standard error of excess returns across all firms The average excess returns is J=M ERt =∑ ERJT J=1 m .BetaJ* RMT Were ERJT is excess return on the firm j for period t. bonus issues or acquisition announcement? A scheme based upon trading on an information event is usually tested with an event study. For example if the capital asset pricing model is employed to control for risk the excess return is calculated as : ERJT = RJT. P/BV ratio or dividend yield? A scheme based upon trading on observable characteristic is tested using portfolio study. stock-splits. •Is it possible to earn superior returns by trading on an observable characteristic of a firm like P/E ratio. Event Study An event study examines the market reactions to and the excess market returns around a specific information event like acquisition announcement or stock split. Semi. Beta J is the beta for firm j.

Semi. ER jt is the excess returns for jth firm for period t and m is the number of firms in the event study. Most event studies support the semi-strong form of efficient market hypothesis. . the sign of the excess returns indicates whether the effect is positive and negative. estimate the T stastics for each day: T Staistic for excess return on day t= Average excess return Standard error • Statistically significant T statics imply that the event has a bearing on returns. • The standard error of the excess return is the standard deviation of the sample average 5) Assess whether the excess returns around the announcement date are different from zero. Results of Event Studies The results of event studies are mixed.Strong Market efficiency Test • Were ERt is the average excess return for period t.

Empirical evidence broadly suggests that following • Corporate insiders and stock exchange specialist( who have who have monoplistic access to buy and sell order position) earn superior rates of return. specialists on stock exchanges and mutual fund managers) who have access to information which is not publicly available. on an average. researchers analysed the returns earned by certain groups(like corporate insiders. . • Mutual fund managers do not. after adjustment of risk. earn superior rate of return. Strong Market efficiency Test To test the strong form efficient market hypothesis.

Saving more money may be a New Year's Resolution for some. many investors unload shares of poorly performing stocks. • Furthermore. the beginning of January is simply a popular time to invest. or a way to put year-end bonuses to work. and it always looks good for a portfolio to contain a few extra "winners. Primarily. year-end trading is heavily influenced by tax considerations. Once the new year begins. though. the proceeds from those sales are often redeployed back into the market. . the last explanation can be attributed to investor psychology.a deceptive practice. One such explanation holds that mutual fund managers will sometimes go shopping at the end of December to purchase stocks that have appreciated significantly during the year -. For many people. • Finally. Whatever the reason. stocks typically trend higher at the beginning of January. known as "window dressing. January Effect • Several theories have been put forth to explain why the January Effect occurs. Some of them may be simply trying to cut their ties to bad investments in order to get a fresh start to the new year. thereby sending stock prices higher." Demand from these institutional investors can sometimes drive prices higher." Any holdings that a fund owns at year-end will be listed in its annual report to shareholders. as the end of the year approaches. and many people will sell their losers in order to realize capital losses that can be used to offset capital gains elsewhere.

Breaking down Monday Effect • Some studies have shown a similar correlation. but no one theory has been able to accurately explain the existence of the Monday effect. on Monday rather than any other day in the week. This theory also states that the returns on Monday are driven by the closing performance of the stock on the previous Friday. • A tendency of a stock market's returns to be relatively lower. come Monday. resume its rise. or may even be negative. if the market was up on Friday. MONDAY EFFECT • A theory that states that returns on the stock market on Mondays will follow the prevailing trend from the previous Friday. This effect generally causes an unstable performance of the stock market during the first hour of the trading day. Therefore. it should continue through the weekend and. .

and these lower prices mean that price appreciations tend to be larger than those found among large cap stocks . Small Firm Effect • A theory that holds that smaller firms. or those companies with a small market capitalization. • Small cap stocks tend to have lower stock prices. outperform larger companies • The theory holds that smaller companies have a greater amount of growth opportunities than larger companies. Small cap companies also tend to have a more volatile business environment which can lead to a large price appreciation.

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