Presentation on:

Efficient Market Theory

Presented By:
Hitesh Punjabi
 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,
therefore, the current prices of securities reflect all relevant information.

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.
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.
According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to
either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the
overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain
higher returns is by purchasing riskier investments.
EMH is highly controversial and often disputed. 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, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also
exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time,
which by definition is impossible according to the EMH.
Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial
Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.
 Classification of Efficient Market Hypothesis

The three classification of efficiency as set out by Fama are:

1) Weak form of efficiency; which absorbs only past price and volume data and those in returns of the
market.
2) Semi-Strong 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. This absorption is of different degrees.
 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.
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, Independent of the past and hence there is no benefit in examining
the past 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, who state historical price movements can help
the forecast the future price trends and the prices move in a predictable manner.

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, policy statements on dividends, rights, bonds and other
corporate information will not yield consistent superior returns to analyst. The reason is that as soon as such
information is publicly available, it is absorbed and reflected in stock prices. Even if the market absorption is
imperfect it will not be possible for the analyst to obtain superior returns on consistent basis.
The absorption even if it is incomplete or incorrect, it will not continue for long and it will not place in same fashion
and in a consistent manner.
There can be over adjustments and under adjustments and in the absence of any consistency, the results are not
predictable and analyst cannot take advantage of the fundamentals and information on them, to gain superior
investment returns
 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.
This means that no information, be it public, private, or inside can be used to consistently earn superior investment
returns by the analyst, because market absorbs all the information by itself.
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, published and present or insider information.
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, can have inside information and
can gain excess profits and empherical tests have proved the same.
The Strong Form states 2 conditions to be met: 1) the Successive price changes or returns are independent and 2)
Successive price changes or return changes are identically distributed.

Random Walk Hypothesis

Several studies address the issue of whether stock price behavior is a random walk or not. Robert (1959) and
Osborne (1959) found that stock price movement follows a random walk.
The random walk hypothesis simply states that at a given point in time, the size(quantum) and direction of the next
price change is random with respect to the knowledge available at that point in time.
According to theory securitys intrinsic values change and market prices move randomly around these intrinsic
values. The new information affecting the market arrives at random intervals. 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 Theory thus states that security prices move randomly in a continuous fashion to set new equilibriums. There
may be upward or downward movements and changes take place in a random manner.
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. Such absorption leads to quick
and prompt movements in prices which are random in fashion.
 Weak-form of market efficiency Test:
There have been four major methods to test the dependence of return on time (Weak-form of market efficiency): serial
correlation tests, filter rule test, Run tests etc.

Serial correlation tests

One way to test for randomness in stock prices changes is to look at their serial correlations (also called auto-
correlations). Is the price changes in one period correlated with the price change in some other period?

if such auto correlation are negligible, the price changes are considered to be serially independent.

Numerous serial correlation studies, employing different stocks, different time-lags and different time- periods, have
been conducted to detect serial correlations.

Initial Studies have failed to discover any significant serial correlations. Subsequent studies discovered minor positive
correlations.

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, 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, sell it

If the behavior of stock prices changes is random, filter rules should not outperform a simple buy-and-hold strategy.

Many Studies have been conducted employing different stocks and different filter rules. By and large, they suggest that
filter rules do not outperform a simple buy-and hold strategy.
 Weak-form of market efficiency Test:

Run Test
Given a series of stock price changes, each price change is designated a a Plus(+) if it represents an increase or a
minus (-) if it represents a decrease. The resulting series , for example, may look as follows:
++-++--+
A run occurs when there is no difference between the sign of two changes. When the sign of change differs, the
run ends and new run begins.
For example in the above series of plus and minuses, there are five runs as follows
++------------1
- -----------2
++--------------3
-- ---------------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.
By and large the results of these studies seem to strongly support the random walk model.
 Semi- Strong Market efficiency Test

To test semi- 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,
stock-splits, bonus issues or acquisition announcement? A scheme based upon trading on an information event is
usually tested with an event study.
Is it possible to earn superior returns by trading on an observable characteristic of a firm like P/E ratio, P/BV ratio
or dividend yield? A scheme based upon trading on observable characteristic is tested using portfolio study.
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. 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, by the period, around the announcement date for each firm in the sample.:- the
excess returns is calculated by making adjustments for market performance and risk. For example if the capital
asset pricing model is employed to control for risk the excess return is calculated as :
ERJT = RJT- BetaJ* RMT
Were ERJT is excess return on the firm j for period t, BetaJ is the beta for firm j, RMT 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
 Semi- Strong Market efficiency Test

Were ERt is the average excess return for period t, ERjt is the excess returns for jth firm for period t and m is the
number of firms in the event study.
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, 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 sign of the excess returns
indicates whether the effect is positive and negative.

Results of Event Studies

The results of event studies are mixed. Most event studies support the semi-strong form of efficient market
hypothesis.
 Strong Market efficiency Test

To test the strong form efficient market hypothesis, researchers analysed the returns earned by certain groups(like
corporate insiders, specialists on stock exchanges and mutual fund managers) who have access to information which
is not publicly available.

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, after adjustment of risk.

Mutual fund managers do not, on an average, earn superior rate of return.

Thank You