CAPITAL MARKET

EFFICIENCY

1
 Introduction
 Capital market theory springs from the
notion that:
• People like return

• People do not like risk

• Dispersion around expected return is a

reasonable measure of risk
2
 Definition
 Capital markets trade securities with lives
of more than one year

 Examples of capital markets

• New York Stock Exchange (NYSE)
• London Stock Exchange (LSE)
• Nairobi Secuties Exchange (NSE)

3
 Economic Function
 The economic function of capital markets
facilitates the transfer of money from savers
to borrowers
• E.g., mortgages, Treasury bonds, corporate
stocks and bonds

4
 Continuous Pricing Function
 The continuous pricing function of capital
markets means prices are available moment
by moment
• Continuous prices are an advantage to investors

• Investors are less confident in their ability to

get a quick quotation for securities that do not
trade often
5
 Fair Price Function
 The fair price function of capital markets
means that an investor can trust the
financial system
• The function removes the fear of buying or
selling at an unreasonable price

• The more participants and the more formal the

marketplace, the greater the likelihood that the
buyer is getting a fair price
6
 Efficient Market Hypothesis
 The efficient market hypothesis (EMH) is
the theory supporting the notion that market
prices are in fact fair
• The EMH is perhaps the most important
paradigm in finance

7
 Types of Efficiency
 Operational efficiency measures how well
things function in terms of speed of
execution and accuracy
• It is a function of the number of order that are
lost or filled incorrectly

• It is a function of the elapsed time between the

receipt of an order and its execution
8
 Types of Efficiency (cont’d)
 Allocational Efficiency
• The market allocate funds to the most efficient
user
• There is no alternative allocation that could
yield higher returns to the economy
• There are enough securities to efficiently
allocate risk
• Funds are allocated directly from SSU to DSU
9
 Types of Efficiency (cont’d)
 Informational efficiency is a measure of
how quickly and accurately the market
reacts to new information
• It relates directly to the EMH

• The market is informationally very efficient if

security prices adjust rapidly and accurately to
new information

10
 Asymmetric Information
 Asymmetric information is when one party to
a transaction has access to more a complete
and accurate set of facts than the other party.
• When this condition exists, it is possible for the
party with better information to use that at their
own personal gain, and at the expense of the other.

11
 Asymmetric Information
An Example – The Used Car!

An example of Asymmetric information from everyday life might be the

situation between a buyer and seller of a used car in a private transaction.
• The seller has intimate knowledge of recent car history including past owners,
collisions, repairs, and problems.
• The buyer (presuming no expertise as a mechanic) has only their limited skills
of observation and investigation to inform their purchase decision.

In the foregoing example, it is possible, in the absence of rules and

regulations, for the seller to take advantage of the buyer because of
information asymmetry. This means, the buyer is likely to pay more for
the car than they should! The seller reaps the rewards of superior
information.
In some provinces, before such a transaction can occur, a sellers information package must be obtained
from the Ministry of Transportation. This package will include an estimate of wholesale and retail
price of the used car, and a list of past owners. This is an example of government regulation to try
to reduce the information advantage sellers have over buyers.

12
Disclosure and Market Efficiency
The Asymmetric Information Challenge

 If informational advantages were widely permitted, and if there were a persistent

advantage of some market participants over others, the credibility of the markets
would be shaken.
 Under such circumstances, many people would choose not to invest in securities,
choosing, instead to put their money into managed deposits, or worse, choosing to
hide their money under a pillow.
 This would significantly reduce the number of market participants, and the amounts
of money invested in the markets.
 The result would be:
• Less market efficiency – and even fewer willing participants!
• Lower security prices in general
• Infrequent trading of securities
• Increasing ability of one market participant to affect the security price through their actions.
 Ultimately, the capital market would not be able to channel sufficient surplus funds
to underwrite economic activity such as plant expansions, research and
development, etc. In the end, companies would lack capital, and increasingly
become inefficient and ineffective in their markets. Jobs would be lost and the
standard of living of all would decline.

13
 Market Efficiency
Requisite Conditions
For markets to operate efficiently some conditions must exist:
1. A large number of rational, profit-maximizing investors exist, who
actively participate in the market by analyzing, valuing, and trading
securities. The markets must be competitive, meaning no one
investor can significantly affect the price of the security through their
own buying or selling.
2. Information is costless and widely available to market participants at
the same time.
3. Information arrives randomly and therefore announcements over time
are not serially connected.
4. Investors react quickly and fully (and reasonably accurately) to the
new information, which is reflected in stock prices.

14
 Weak Form
 The weak form of the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past
• The current price is a fair one that considers
any information contained in the past price data

• Charting techniques are of no use in predicting

stock prices
15
 Definition (cont’d)
Example

Which stock is a better buy?

Stock A

Current Stock Price

Stock B

16
 Definition (cont’d)
Example (cont’d)

Solution: According to the weak form of the EMH, neither

stock is a better buy, since the current price already
reflects all past information.

17
 Charting
 People who study charts are technical
analysts or chartists
• Chartists look for patterns in a sequence of
stock prices

• Many chartists have a behavioral element

18
 Runs Test
 A runs test is a nonparametric statistical
technique to test the likelihood that a series
of price movements occurred by chance
• A run is an uninterrupted sequence of the same
observation
• A runs test calculates the number of ways an
observed number of runs could occur given the
relative number of different observations and
the probability of this number
19
 Semi-Strong Form
 The semi-strong form of the EMH states
that security prices fully reflect all publicly
available information
• E.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.

20
 Semi-Strong Form (cont’d)
 Academic research supports the semi-strong
form of the EMH by investigating various
corporate announcements, such as:
• Stock splits
• Cash dividends
• Stock dividends
 This means investor are seldom going to
beat the market by analyzing public news
21
 Security Prices and
Random Walks
 The unexpected portion of news follows a
random walk
• News arrives randomly and security prices
adjust to the arrival of the news
– We cannot forecast specifics of the news very
accurately

22
 Empirical Evidence on Semi-strong Efficiency
Semi-Strong Form Evidence

 Tests of the Semi-strong Form of EMH include:

• Event (announcement) studies including ‘earnings
surprises’ and corporate announcements to examine
the impact of particular events on stock prices
• Examination of the performance of investors to see
if they can use publicly available information to
consistently generate abnormal returns

23
 Empirical Evidence on Semi-strong Efficiency
Event Studies

 Event studies examine stock returns to determine the impact of a

particular event on stock prices, in particular, what happens to the
stock price, before, during and following the event.
 Events include:
• Company-specific announcements such as stock splits, takeover
announcements, dividend changes, accounting changes.
• Economy-wide changes such as unexpected interest rate changes

Figure 1(on the following slide) illustrates the price adjustment process for:
(A) – an efficient market
(B) - overreaction in an efficient market
(C) - slow reaction in an efficient market

24
Empirical Evidence on Semi-strong Efficiency
Efficient (A) and Inefficient Markets (B) and (C)

FIGURE 1

Stock Price

A
$23 C

$20

Time
t
Announcement Date

25
 Empirical Evidence on Semi-strong Efficiency
Typical Event Study Results

 Most event studies have shown that stock prices change before the
announcement as demonstrated in Figure 2 on the following slide.
 These results demonstrate that an investor cannot move quickly enough at
the time an event occurs (announcement is made) to profit from the
change, so this speaks to market efficiency in the semi-strong form,

On the other hand

 This evidence does not provide support for the strong form of the EMH
because some investors are profiting from private information about
impending price changes.

26
Empirical Evidence on Semi-
strong EMH
Typical Event Study Result for Good News Event
FIGURE 2

Stock Price

A
$23 C

$20

Time
t
Announcement Date

27
 Strong Form
 The strong form of the EMH states that
security prices fully reflect all public and
private information
 This means even corporate insiders cannot
make abnormal profits by using inside
information
• Inside information is information not available
to the general public
28
 Strong Form Tests
 Tests of this hypothesis include determining whether any group
of investors has information that allows them to earn abnormal
profits consistently.
• Several studies found consistent abnormal profits
• Others found only slightly better than average returns.
 It should be noted that insider trading laws do
restrict the ability of insiders to act and
therefore, profit from their inside information,
so this is one reason why evidence may be
muted regarding the ‘degree’ of advantage
insiders enjoy under current law.
29
 Anomalies
 A financial anomaly refers to unexplained
results that deviate from those expected
under finance theory
• Especially those related to the efficient market
hypothesis

30
 Low PE Effect
 Stocks with low PE ratios provide higher
returns than stocks with higher PEs

 Supported by several academic studies

 Conflicts directly with the CAPM, since

study returns were risk-adjusted
31
 Low-Priced Stocks
 Stocks with a “low” stock price earn higher
returns than stocks with a “high” stock price

 There is an optimum trading range

 Every stock with a “high” stock price

should split
32
 Small Firm Effect
 Investing in firms with low market
capitalization will provide superior risk-
adjusted returns

 Supported by academic studies

 Implies that portfolio managers should give

small firms particular attention
33
 Neglected Firm Effect
 Security analysts do not pay as much
attention to firms that are unlikely portfolio
candidates

 Implies that neglected firms may offer

superior risk-adjusted returns

34
 Market Overreaction
 The tendency for the market to overreact to
extreme news
• Investors may be able to predict systematic
price reversals

 Results because people often rely too

heavily on recent data at the expense of the
more extensive set of prior data
35
 January Effect
 Stock returns are inexplicably high in
January

 Small firms do better than large firms early

in the year

 Especially pronounced for the first five

trading days in January
36
 January Effect (cont’d)
 Possible explanations:
• Tax-loss trading late in December

• The risk of small stocks is higher early in the

year

37
 Day-of-the-Week Effect
 Mondays are historically bad days for the
stock market transactions based on
depressed volumes
 Wednesday and Fridays are consistently
good

 Tuesdays and Thursdays are a mixed bag

38
 Day-of-the-Week
Effect (cont’d)
 Should not occur in an efficient market
• Once a profitable trading opportunity is
identified, it should disappear

 The day-of-the-week effect continues to

persist

39
 Turn-of-the-Calendar Effect
 The bulk of returns comes from the last
trading day of the month and the first few
days of the following month

 For the rest of the month, the ups and

downs approximately cancel out

40
 Persistence of
Technical Analysis
 Technical analysis refers to any technique
in which past security prices or other
publicly available information are
employed to predict future prices
 Studies show the markets are efficient in the
weak form
 Literature based on technical techniques
continues to appear but should be useless
41
 Chaos Theory
 Chaos theory refers to instances in which
apparently random behavior is systematic or
even deterministic
 “Econophysics” refers to the application of
physics principles in the analysis of stock
market behavior
• E.g., an investment strategy based on studies of
turbulence in wind tunnels
42