Efficient Capital Markets

Why should capital markets be efficient

 Informationally Efficient Market : In an efficient capital market,
security prices adjust rapidly to the infusion of new information, and,
therefore, current security prices fully reflect all available information.
This is referred to as an informationally efficient market.
 An important premise of Efficient market:
» A large number of profit maximizing participants analyze and value
securities
» New information regarding securities comes to the market in a random
fashion
» Profit maximizing investors adjust security prices rapidly to reflect the
effect of new information
– Therefore price changes are independent & random
» The expected return implicit in the current price of the security should
reflect its risk
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 Alternative efficient market Hypothesis
 Weak form efficient market hypothesis
» It assumes that current stock prices fully reflect all security market
information including the
– Historical sequence of prices
– Rates of returns
– Trading volume data
– Market generated information, like
– Odd lot transactions
– Block trades
– Transaction by exchange specialist
» According to this hypothesis an investor cannot achieve positive risk
adjusted return on average by using technical analysis

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 Alternative efficient market Hypothesis
 Semi-strong form efficient market hypothesis
» It asserts that security prices adjust rapidly to the release of all public
information

» Weak Form is a subset of semi strong form

» This hypothesis implies that investors who base their decisions on any
important new information after it is public should not derive above
average risk adjusted profits

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 Alternative efficient market Hypothesis
 Strong Form Efficient Market Hypothesis

» It contends that stock prices fully reflect all information from public
and private sources

» No group of investors have monopolistic access to information

» It also extends the assumption of efficient markets in which prices

adjust rapidly to the release of new public information

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 Test and Results of EMH
 Weak Form Hypothesis: Test and Results
» Researchers have formulated two groups of test for this hypothesis

– Statistical test of independence

– Auto correlation test – These tests indicate that security returns are not
significantly correlated over time
– Run test– they have confirmed independence of stock price over time

– Test of Trading Rules

– Three pitfalls to be aware of: use of only public data, include transaction cost &
adjust for risk
– Investors cannot earn abnormal returns after accounting for transaction costs,
commission etc.

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 Test and Results of EMH
 Semi Strong Form Hypothesis Test and results

» Researchers have formulated two studies for it

– Studies that predict future rates using public information beyond pure
market information

– Quarterly results and their impact

– Event studies examine how fast stock prices adjust to specific economic
events

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 Test and Results of EMH
 Anomalies for Semi-strong EMH

 Quarterly earnings reports :Studies that address quarterly reports are considered
part of the times-series analysis. Specifically, these studies examine whether it is
possible to predict future individual stock returns based on publicly available
information on changes in quarterly earnings that differed from expectations.
 The January Anomaly : The January Anomaly is the tendency for stock prices to
rise in the first month of the year following a year-end sell-off for tax purposes.

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 Price to Earnings Ratio  is the ratio of a company's share price to the company's
earnings per share. The ratio is used for valuing companies and to find out whether they
are overvalued or undervalued. A high P/E ratio could mean that a company's stock is
overvalued, or else that investors are expecting high growth rates in the future .

 The size effect tells that the returns of small firms are significantly larger than returns
of larger firms.

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 The neglected firm effect: The companies that are followed by fewer analysts
will earn higher returns on average than companies that are followed by many analysts.

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 Test and Results of EMH
 Strong Form Hypothesis: Test and Results

 Corporate Insiders: Corporate insiders are required to report monthly to the SEC
on their transactions (purchases or sales) in the stock of the firm for which they are
insiders.
 Security Analysts: set of analysts who have the ability to select undervalued stocks.
 Performance of professional money managers: The studies of professional
money managers are more realistic and widely applicable than the analysis of insiders
because money managers typically do not have monopolistic access to important new
information but are highly trained professionals who work full time at investment
management. Therefore, if any “normal” set of investors should be able to derive above-
average profits, it should be this group.

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 Implications of EMH & Anomalies
 Efficient Markets and Technical Analysis: The EMH indicates that
technical analysis should be of no value.

 Efficient Markets and Fundamental analysis: All forms of

fundamental analysis are useful, but they are difficult to implement
because they require the ability to estimate future values for relevant
economic variables.
 Efficient markets and portfolio management: Superior analysis is
possible but difficult because it requires superior projections that
differ from the consensus. Those who manage portfolios should
constantly evaluate investment advice to determine whether it is
superior.

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