Chapter 4- Efficient Market Hypothesis 1

 Include
how much debt and equity to sell,
what type of debt and equity to sell and
when to sell them.

Chapter 4- Efficient Market Hypothesis 2

1. Fool Investors – Financial managers try to package
securities to receive the greatest value. For example
a firm would issue a more complex security such as
a combination of stocks and warrants. The firm may
be able to get more than the fair value if the
investors are misguided.
 In efficient market, securities are appropriately
priced at all times.
 Empirical evidence suggests that it is hard to fool
investors consistently since the market as a whole is
very shrewd.

Chapter 4- Efficient Market Hypothesis 3

2. Reduce Costs or Increase Subsidies
a) Certain forms of financing have tax advantages
or carry other subsidies. Firms can package
securities to minimize tax, therefore increase
value.
b) A firm can also minimize financing costs such as
fees of investment bankers, lawyers, accountants,
etc, so as to increase value.
c) Financing vehicles that provide subsidies would
also create value

Chapter 4- Efficient Market Hypothesis 4

3. Create a New Security
i. Sometimes a firm can find a previously-unsatisfied
clientele and issue new securities such as zero- coupon
bond, convertible adjustable preference stock, floating
rate notes, zero-coupon convertible bond, auction-rate
preference stocks at favorable prices. These new
securities cannot easily be duplicated by combining
existing securities. A previously unsatisfied clientele
may pay extra for a specialized security catering to its
needs.
ii. Companies gain by issuing these unique securities at
high prices. In the long-run, this value creation is
relatively small.

Chapter 4- Efficient Market Hypothesis 5

1. An efficient capital market is one in which
stock prices fully reflect available
information. If there is announcement or new
information, the prices would immediately
adjust to this information.
2. Market efficiency refers to the precision in
which the market prices securities.
3. An efficient market may not be perfect.

Chapter 4- Efficient Market Hypothesis 6

1. Security prices reflect all available
information concerning a firm.
2. Security prices fully incorporate known
information.
3. Prices change rapidly to known/knowable
information
4. Information disseminates rapidly.
5. Day to day price changes will follow in a
“random walk” over time.

Chapter 4- Efficient Market Hypothesis 7

1. Investments in financial securities are zero NPV
projects. Therefore, investors should expect to obtain
normal rate of return.
2. Since information is reflected in security prices
quickly, knowing information when it is released
does an investor no good. The price adjusts before
the investor has time to trade on it.
3. Firms should expect to receive the fair value for
securities that they sell. Fair means that the price
they receive for the securities they issue is the
present value. Firms cannot profit from fooling
investors in an efficient market.

Chapter 4- Efficient Market Hypothesis 8

1. These are information possessed by people in
special position inside the company.
2. An investor can profit from inside
information by investing in the company’s
stock if he/she obtained good news about the
company or he/she can sell his/her stocks
when he/she obtained bad news about the
company.

Chapter 4- Efficient Market Hypothesis 9

Overreaction to “good news”
with reversion

Slow/Delayed
response to “good
news”
Efficient market response
New information is leaked and
to “good news price respond before public
dissemination

-30 -20 -10 0 +10 +20 +30

Public Announcement date

Chapter 4- Efficient Market Hypothesis 10

 Slow/Delayed
response to
Efficient market response to “bad “bad news”
Stock news
Price

-30 -20 -10 0 +10 +20 +30

Overreaction to “bad news” with Days before (-) and after (+)
reversion announcement

Chapter 4- Efficient Market Hypothesis 11

1. In an efficient market, prices respond
instantaneously to new information and fully
reflect that information.
2. After the public announcement date, no further
changes take place in the stock price.
3. The delayed response usually takes 30 days to fully
absorb the information.
4. Delayed response (under-reaction and over-
reaction) to new information would suggest that the
market is inefficient.

Chapter 4- Efficient Market Hypothesis 12

1. Previously, we assumed that the market responds
immediately to all available information. In
actuality, certain information may affect stock
prices more quickly than other information
2. To handle differential response rates, researchers
separate information into:
1. Information on past prices
2. Publicly available information
3. All information

Chapter 4- Efficient Market Hypothesis 13

1. Weak Form
2. Semi-Strong Form
3. Strong Form

Chapter 4- Efficient Market Hypothesis 14

i. Security prices reflect all information found in past
prices and volume.
ii. If the weak form of market efficiency holds, then
technical analysis is of no value.
iii. Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t
◦ Price today is equal to the sum of the last observed
price plus the expected return on the stock plus a
random component occurring over the interval.

Chapter 4- Efficient Market Hypothesis 15

iv. Since stock prices only respond to new
information, which by definition arrives randomly,
stock prices are said to follow a random walk.
v. The expected return is a function of a security’s
risk and would be based on the models of risk and
return.
vi. The random component is due to new information
on the stock. It could be either positive or negative
and has an expectation of zero.

Chapter 4- Efficient Market Hypothesis 16

  Investor behavior tends to eliminate any profit opportunity
associated with stock price patterns.
Stock Price

Sell
Sell
If it were possible to make big
money simply by finding “the
pattern” in the stock price
Buy movements, everyone would
Buy do it and the profits would be
competed away.

Time
Chapter 4- Efficient Market Hypothesis 17
1. It is cheap and easy to find patterns in stock prices
2. Anyone who can program a computer and knows a
little bit of statistics can search for such pattern. If
there were such patterns, people would find and
exploit them in the process, causing the profits to
disappear.
3. Cyclical regularities would be eliminated, leaving
only random fluctuations. This implies that stock
selection based on patterns of price movement will
not provide abnormal returns. Thus, technical
analysis is useless.

Chapter 4- Efficient Market Hypothesis 18

1. Security Prices reflect all publicly available
information.
2. Publicly available information includes:
a) Historical price and volume information
b) Published accounting statements.
c) Information found in annual reports.

Chapter 4- Efficient Market Hypothesis 19

3. Uses more sophisticated information and reasoning
than weak form efficiency
4. Requires not only that market be efficient with
respect to historical price information, but that all of
the information available to the public be reflected
in the price
5. It implies that most fundamental analysis is
useless.

Chapter 4- Efficient Market Hypothesis 20

1. Security Prices reflect all information
- public and private.
2. Strong form efficiency incorporates weak
and semi-strong form efficiency.

Chapter 4- Efficient Market Hypothesis 21

3. Strong form efficiency says that anything
pertinent to the stock and known to at least
one investor is already incorporated into the
security’s price.
4. There are no such things as secrets
5. No one can consistently beat the market and
make abnormal returns.

Chapter 4- Efficient Market Hypothesis 22

 Information set
of publicly available
information

Information
set of
past prices

Chapter 4- Efficient Market Hypothesis 23

1. Use serial correlation to find the correlation
between the current return on security and the
return on the same security over a later period.
2. The correlation will indicate whether or not there
are relationship between yesterday’s returns and
today’s returns.
1. A +ve coefficient of serial correlation for a
particular stock indicates tendency towards
continuation.
2. A –ve coefficient indicates tendency towards
reversal.

Chapter 4- Efficient Market Hypothesis 24

3. Both significantly +ve and –ve serial correlation are
indications of market being inefficient.
4. Serial correlation coefficients for stock returns near
zero would be consistent with the random walk
hypothesis.
5. Findings from previous tests showed a very low
correlation coefficients.
6. The evidence taken as a whole is strongly
consistent with weak-form efficient.

Chapter 4- Efficient Market Hypothesis 25

These coefficient are so Company Serial Correlation
small relative to both
Coefficient
estimation error and to
transaction cost that the Coca Cola 0.041
results are generally
Boeing Co. 0.038
considered to be consistent
with the weak form IBM -0.004
efficiency.

Chapter 4- Efficient Market Hypothesis 26

1. Use Event Studies
- examine the following relationship:
 Information released at time t – 1 ↔ AR t-1
 Information released at time t ↔ AR t
 Information released at time t+1 ↔ AR t+1

Indicate that the return in any time period is

related only to the information released during
that period.

Chapter 4- Efficient Market Hypothesis 27

 AR can be measured by: R – Rm
Market’s return on the
Stock’s actual return on a same day measured by
particular day the S&P 500 or CI
•EMH says , a stock’s AR at time t, should reflect the
release of information at the time t.
•Any information released before, should have no effect on
abnormal returns in this period, because all of its influence
should have been felt before
•Stock’s return today, cannot depend on what the market
does not know yet.

Chapter 4- Efficient Market Hypothesis 28

1. +ve cumulative abnormal return (CAR) were
observed before the stock split
2. +ve CAR were also observed around the
time the split was announced. After the split,
no further tendency for the CAR to increase.
Therefore, it is consistent with the semi-
strong form of efficiency.

Chapter 4- Efficient Market Hypothesis 29

 Cumulative Abnormal Returns for Companies Announcing Dividend
Omissions
Cumulative abnormal returns (%)

0.146 0.108 0.032 0

-0.244
-8 -6 -4 -2 -0.483 0 2 4 6 8
-0.72
-1

-2

-3
-3.619
-4
-4.563-4.747-4.685-4.49
-5 -5.015 -4.898
-5.183
-5.411
-6

Days relative to announcement of dividend omission

Chapter 4- Efficient Market Hypothesis 30

1. Over the years, event study methodology has been
applied to a large number of events including:
i. Dividend increases and decreases
ii. Earnings announcements
iii. Mergers
iv. Capital Spending
v. New Issues of Stock
2. The studies generally support the view that the
market is semi strong-from efficient.
3. In fact, the studies suggest that markets may even
have some foresight into the future - in other
words, news tend to leak out in advance of public
announcements.

Chapter 4- Efficient Market Hypothesis 31

1. If the market is semi strong-form efficient, then no
matter what publicly available information mutual-
fund managers rely on to pick stocks, their average
returns should be the same as those of the average
investor in the market as a whole.
2. We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.
3. Findings: They do not out perform the market
indices. Therefore, it is consistent with semi-strong
and weak form efficiency.

Chapter 4- Efficient Market Hypothesis 32

1. One group of studies of strong-form market
efficiency investigates insider trading.
2. A number of studies support the view that
insider trading is abnormally profitable.
3. Thus, strong-form efficiency does not seem
to be substantiated by the evidence.

Chapter 4- Efficient Market Hypothesis 33

1. Size: Stocks with small market capitalization
outperform stocks with large market capitalization.
2. Temporal Anomalies:
a) Average stock returns in January are higher than in
other months for both large and small capitalization
securities.
b) Stock returns are highest on Wednesdays and Fridays
and lowest on Mondays.
c) Average stock returns in US have been negative on
Mondays.
d) Average stock returns are significantly higher over the
first half of the month than over the second half of the
month.
Chapter 4- Efficient Market Hypothesis 34
3. Value versus Glamour/growth
1. Value stocks outperform glamour/growth stocks
2. Differences in average return of these stocks is as much as
8 % per annum.
4. Limits to Arbitrage: Stock prices rarely traded at parity
suggests limits to arbitrage.
5. Earnings surprises:
a. Stock prices adjust slowly to earnings announcements.
b. Investors exhibit conservatism because they are slow to
adjust to the information contained in the announcement

Chapter 4- Efficient Market Hypothesis 35

a) Stock crash or overreact without apparent reasons
b) The market dropped between 20%-25% on Monday following
a weekend during which little surprising news was released.
c) A drop of this magnitude for no apparent reason is not
consistent with market efficiency
d) Stock market crashed/dropped is the evidence of bubble
theory of market speculation.
e) That is security prices sometimes moves wildly above their
true values. Eventually, prices fall back to its original level
causing great losses for investors. Example the internet
stocks in late 1990s.

Chapter 4- Efficient Market Hypothesis 36

1. Rationality: When new information is released in the
marketplace, all investors will adjust their estimates of
stock prices in rational way. They would behave in an
identical manner and take quick action to buy or sell
securities. Their rapid and uniform action will ensure
efficiency.
2. Independent deviations from rationality: If many
individuals were irrationally optimistic as were
irrationally pessimistic, prices would likely rise in a
manner consistent with market efficiency, even though
most investors would be classified as less than fully
rational. The market can still be efficient assuming that
the actions of those irrationally optimistic are offset by
that of those irrationally pessimistic.
Chapter 4- Efficient Market Hypothesis 37
3. Arbitrage generates profit from simultaneous
purchase and sale of different but substitute
securities. If the arbitrage of one group of
professionals dominates the speculation of
amateurs, markets would still be efficient. In
other words, competition among
professionals and amateurs makes the
market efficient.

Chapter 4- Efficient Market Hypothesis 38

1. Rationality
◦ Investors on the whole are rational. They behave in an identical
manner and take quick action to buy or sell securities. Their
rapid and uniform action ensure efficiency.
2. Independent Deviations from rationality
◦ Market can still be efficient on the assumption of offsetting
irrationality
3. Arbitrage
◦ While many investors act on emotions and cause unrealistic
price increases or decreases, their action cannot be compared to
the professionals whose actions dominates the market. These
professionals act methodically and rationally by quickly buying
underpriced securities and selling overpriced securities
(arbitraging) which ensures that the market remains efficiency.

Chapter 4- Efficient Market Hypothesis 39

1. Rationality
◦ People are not always rational. For example, many
investors fail to diversify, trade too much and too
frequently thus incurring both commissions and
taxes, and seem to try to maximize taxes by
selling winners and holding losses.

Chapter 4- Efficient Market Hypothesis 40

2. Independent Deviations from Rationality
◦ Psychologists argue that people deviate from rationality
in predictable ways:
a. Representativeness: drawing conclusions from too
little data
 This can lead to bubbles in security prices
b. Conservatism: people are too slow in adjusting their
beliefs to new information.
 Security Prices seem to respond too slowly to
earnings surprises.
Conclusion: Deviations from rationality are similar across
investors

Chapter 4- Efficient Market Hypothesis 41

3. Arbitrage
◦ Suppose that your superior, rational, analysis
shows that company ABC is overpriced.
◦ Arbitrage would suggest that you should short
the shares.
◦ After the rest of the investors come to their
senses, you make money because you were smart
enough to “sell high and buy low”.
◦ But what if the rest of the investment community
doesn’t come to their senses in time for you to
cover your short position?
 This makes arbitrage risky.

Chapter 4- Efficient Market Hypothesis 42

1. The efficacy of dart throwing - Investors can throw
darts to select stocks
 This is almost, but not quite, true. On average,
the investor will not be able to achieve an
abnormal or excess return.
 An investor must still decide how risky a
portfolio he wants based on risk aversion and the
level of expected return.

Chapter 4- Efficient Market Hypothesis 43

2. Prices fluctuations
When the prices of stock continuously change,
investors assume that these fluctuations indicate
market inefficiency. On the contrary, such
fluctuations show that the market is efficient
because information is incorporated in the prices
once it is available, causing the prices to change
continuously to reflect new information.

Chapter 4- Efficient Market Hypothesis 44

3. Shareholders’ Disinterest
a. Since only a small number of investors
actively trade on any given day, some people
misconceive that the market is inefficient.
However , this is not true.
b. Securities can be expected to be efficiently
priced as long as a number of interested traders
use the publicly available information.

Chapter 4- Efficient Market Hypothesis 45

1. The price of company’s stock cannot be affected by change
in accounting policies.
◦ A switch from accelerated method to straight line method
generally do not significantly affect stock price although
there is significant change in earnings.
o No evidence that stock market was affected by the artificially
high earnings reporting using pooling method (recorded at
CV) compared to the purchase method (recorded at FV).
o Firms switching to LIFO method of costing inventory,
experienced an increase in stock price during inflation.
o In a semi-strong market, price is likely to be affected if
company were either withholding useful information or
provide incorrect information.

Chapter 4- Efficient Market Hypothesis 46

2. Finance managers cannot time the issuance of stocks
and bonds
- Efficient market will always correctly price the
stocks
- Therefore, there is hardly any point for managers
to time their issuance of stocks and bonds

Chapter 4- Efficient Market Hypothesis 47

3. Speculation and Efficient Market (Price-pressure Effect)
- If markets are efficient, a firm can sell as many bonds or
shares as it desires without depressing the price.
- Market has the ability to absorb large blocks of stocks
without depressing prices.
- Krans and Stoll, using intra-day prices found clear evidence
of price-pressure. However, the effects were small, i.e. less
than 1%
- Dann, Mayers and Robb and Holthausen, Leftwich and
Mayers using transaction date, found that prices reduced by
an average of 4.5% and recovered within 15 minutes.

Chapter 4- Efficient Market Hypothesis 48

4. Information in market prices
o Current and past price of any assets are known and can be
used to forecast future market price
o Market efficiency implies that stock prices reflect all
available information.

Chapter 4- Efficient Market Hypothesis 49