Efficient Capital

Markets

Dr. Amir Rafique

Investment Analysis/ Securities
Analysis/ Equity Analysis
 The methods used to analyze securities and make
investment decisions fall into two very broad categories:
Fundamental Analysis and Technical Analysis

 Fundamental Analysis

 The method for forecasting the future behavior of investment and

the rate of return through an analysis of the broad economic
forces, industry analysis, the company analysis
Investment Analysis/ Securities
Analysis/ Equity Analysis
 Technical Analysis

 Technicians (some time called chartists) are only

interested in the price movement in the market

 Technical analysis really just studies supply and

demand in a market in an attempt to determine
what direction, or trend, will continue in the future
Two Superior Factors of
Security Valuation

 You must be correct in your estimates

 You must be different from the consensus

Efficient Capital Markets
 In an efficient capital market, security prices
adjust rapidly to the arrival of new information,
therefore the current prices of securities reflect all
information about the security (True value,
Intrinsic value, Fundamental value)

 Whether markets are efficient has been

extensively researched and remains controversial
Efficient Capital Markets
 The most important paradigm in finance

 The EMH deals with informational efficiency,

which is a measure of how quickly and
accurately the market digests new information/
or reacts to new information

 Markets are informationaly quite efficient

Assumptions of the Efficient
Market Hypothesis
 A large number of profit maximizing participants
analyze and value securities, each independently of
the others
 New information regarding securities comes to the
market in a random fashion, and the timing of one
announcement is generally independent of others
 Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
 The expected returns implicit in the current price of
the security should reflect its risk
Assumptions of the Efficient
Market Hypothesis
 Investors are rational

 Irrationalities tend to cancel each other out

 To the extent that investors are not randomly

irrational, they are met in the marketplace by
rational arbitrageurs, who eliminate any
remaining irrational pricing elements
Alternative Efficient Market
Hypotheses (EMH)
 Random Walk Hypothesis – changes in security prices
occur randomly, because unexpected news arrive
randomly

 Fair Game Model – current market price reflect all

available information about a security and the expected
return based upon this price is consistent with its risk

 Efficient Market Hypothesis (EMH) - divided into three

sub-hypotheses depending on the information set
involved
Efficient Market Hypotheses
(EMH)
 Weak-Form EMH - prices reflect all Security-
Market information

 Semi-Strong-Form EMH - prices reflect all

Security Market and Public information

 Strong-Form EMH - prices reflect all Security

Market, Public and Private information
Weak-Form EMH
 Current prices reflect all security-market
information, including the historical sequence
of prices, rates of return, trading volume data,
and other market-generated information

 This implies that past rates of return and

other historical market data should have no
relationship with future rates of return
Semistrong-Form EMH
 Current security prices reflect all public
information, including market and non-market
information

 This implies that decisions made on new

information after it is public should not lead to
above average risk adjusted profits from
those transactions
Strong-Form EMH
 Stock prices fully reflect all information from public and
private sources

 This implies that no group of investors should be able to

consistently derive above-average risk-adjusted rates of
return

 This assumes perfect markets in which all information is

cost-free and available to everyone at the same time

 Inside information is formally called material, nonpublic

information (Private Information)
Semi-Efficient Market
Hypothesis
 Some stocks are priced more efficiently than
others

 Small and new stocks are not priced as efficiently

as the shares of well-known companies

 The markets have several tiers

 Not possible to follow every security

Efficient and Inefficient
Markets
EMH, Technical and Fundamental
Analysis

(Implications of Efficient Capital

Market)
Efficient Markets
and Technical Analysis
 Assumptions of technical analysis directly oppose
the notion of efficient markets

 Stock prices move in trends that persist

 Technicians believe that new information is not

immediately available to everyone, but disseminated
from the informed professional first to the aggressive
investing public and then to the masses
Efficient Markets
and Technical Analysis
 Technicians also believe that investors do not
analyze information and act immediately

 Therefore, stock prices move to a new

equilibrium after the release of new
information in a gradual manner, causing
trends in stock price movements that persist

 Contradict EMH (Weak-form hypothesis)

Efficient Markets
and Fundamental Analysis
 Fundamental analysts believe that there is a
basic intrinsic value for the securities and
these values depend on underlying economic
factors

 Investors should determine the intrinsic value

of an investment at a point in time and
compare it to the market price
Efficient Markets
and Fundamental Analysis
 If you can do a superior job of estimating
intrinsic value you can make superior market
timing decisions and generate above-
average returns

 This involves aggregate market analysis,

industry analysis, company analysis, and
portfolio management
Efficient Markets and Investment
Analysis/ Portfolio Management
 Passive Investment Strategies

 Buy-and-Hold Policy

 Passive Portfolio Diversification

 Market funds/ Index funds

The New Finance
The New Finance
 Stock Market Bubbles/ Crashes
 The Great Depression
 The Black Monday
 Dot Com Bubble/Crash
 The Financial Crisis 2008
 KSE-100 Crash 2005
 KSE-100 Crash 2008

 What is the answer then?

Anomalies
 Anomaly refers to unexpected results that
deviate from those expected under finance
theory, especially those related to EMH
 Anomalies are:
 Low P/E effect
 Low-Priced stocks
 The Small firm effect (low capitalization)
 The Neglected firm effect (semi-EMH)
 The January effect/ The Weekend effect
 The Over reaction effect
Behavioral Finance
 Investors are irrational

 It is concerned with the analysis of various psychological

traits of individuals and how these traits affect the
manner in which they act as investors, analysts, and
portfolio managers (Behavioral Aspects of Investors)

 The Notion of Behavioral Finance is “Herd Mentality”

 Behavioral Finance
 The standard finance model of rational behavior is incomplete as
does not consider individual behavior

 There is no unified theory of behavioral finance

 Investors have a number of biases, so anomalies…..

 Biases are:
 Disposition affect
 Overconfidence
 Confirmation bias
 Herd behavior
 Loss aversion/ Escalation bias
A Well-Functioning Market
Test and Results of Different Sub-
Hypotheses
Test and Results of Different
Sub-Hypotheses
 The evidence on the EMH is mixed

 Anomalies contradict EMH

Tests and Results of
Weak-Form EMH
 Two groups of tests of the weak-form EMH

 Statistical tests of independence between rates of

return

 Comparison of risk-return results for trading rules

Tests and Results of
Weak-Form EMH
 Statistical tests of independence
 Security returns over time should be
independent of one another
 Two major statistical tests of independence:
 Autocorrelation tests have mixed results
 Does the rate of return on day t correlate with the rate
of return on day t-1, t-2, t-3? (should be insignificant
correlations for weak form EMH)
 Runs tests indicate randomness in prices
 Each price change is either designated + or -
Tests and Results of
Weak-Form EMH
 Statistical tests of trading rules

 Statistical tests of independence are too rigid:

 Filter rule, an investor trades a stock when the

price change exceeds a filter value set for it (a 5%
filter rule)
Tests of the Semistrong Form
of Market Efficiency
 Security prices fully reflect all public information

 The following set of studies are available:

 Studies to predict future rates of return using available
public information
 Time series analysis of returns or the cross section distribution
of returns for individual stocks

 Event studies that examine how fast stock prices adjust to

specific significant events
 Public information/ event/ news
Tests of the Semistrong Form
of Market Efficiency
 Adjustment for Market Effects
 For any of these tests, we need to adjust the
security’s rates of return for the rates of returns of
the overall market during the period considered

 This assumption meant that the market

adjustment process simply derive abnormal rate
of return, as follows:
ARit = Rit - Rmt
Tests of the Semistrong Form
of Market Efficiency
 Adjustment for Market Effects

 Since 1970, after CAPM

 Determine the abnormal return by computing

the difference between the stock’s actual rate
of return and its expect rate of return (based
on beta) which is as follows:
ARit = Rit – E(Rit)
Tests of the Semistrong Form
of Market Efficiency
 Adjustment for Market Effects

 Over the normal long-run period, you would expect

the abnormal returns for a stock to sum to zero

 There are two sets of tests of the semi-strong form

EMH
 Return prediction studies
 Event studies
Results of Return Prediction
Studies
 The time series analysis assumes that in an efficient market the
best estimate of future rates of return will be the long-run historical
rates
 Quarterly Earning Reports
 The January Anomaly
 Other Calendar Effects

 Predicting Cross-sectional Returns

 Price-earnings (P/E) ratios
 Price-Earnings/ Growth Rate (PEG) ratios
 The Size Effect
 Neglected Firms and Trading Activity
 Book Value-Market Value Ratio
 Results of Event Studies
 To examine abnormal rate of return surrounding significant
economic information
 Stock Split Studies
 Initial Public Offerings (IPOs)
 Exchange Listing
 Unexpected World Events and Economic News
 Announcements of Accounting Changes
 Corporate Events

 Stock prices quickly adjust to unexpected world events and economic

news and hence do not provide opportunities for abnormal profits
 Announcements of accounting changes are quickly adjusted for and do
not seem to provide opportunities
 Stock prices rapidly adjust to corporate events such as mergers and
offerings
Tests and Results of
Strong-Form EMH
 Strong-form EMH contends that stock prices fully reflect
all information, both public and private

 This implies that no group of investors has access to

private information that will allow them to consistently
earn above-average profits

 More difficult to conduct

 Unusual increase in trading volume by analyzing different

investment groups
Testing Groups of Investors
 The performance of following four major
groups of investors is analyzed to test this
form of EMH:

 Corporate insiders
 Stock exchange specialists
 Security analysts
 Professional money managers
Corporate Insider Trading
 Corporate insiders include major corporate
officers, directors, and owners of 10% or more
of any equity class of securities

 Corporate insiders generally experience above-

average profits

 This implies that many insiders had private

information from which they derived above-
average returns on their company stock
Stock Exchange Specialists
 Specialists have monopolistic access to
information about unfilled limit orders

 You would expect specialists to derive

above-average returns from this information

 The data generally supports this expectation

 Security Analysts
 Tests have considered whether it is possible to
identify a set of analysts who have the ability to
select undervalued stocks

 This looks at whether, after a stock selection by

an analyst is made known, a significant
abnormal return is available to those who follow
their recommendations
Professional Money Managers
 Trained professionals, working full time at
investment management

 If any investor can achieve above-average

returns, it should be this group

 If any non-insider can obtain inside information,

it would be this group due to the extensive
management interviews that they conduct
Issues