The Efficient Capital Markets By Ding zhaoyong

Main Contents The concept of efficient capital markets Alternative efficient market hypotheses The tests and results of EMHs The implication of EMHs

Efficient Capital Markets 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 information about the security. Efficient Market Hypotheses (EMH ) are those alternative hypotheses which consider the efficiency of the markets

Efficient Capital Markets An efficient capital market imply: –A large number of competing 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 independent of others

Efficient Capital Markets –The competing investors attempt to adjust security prices rapidly to reflect the effect of new information, although imperfect and unbiased. –The security prices that prevail at any times should be an unbiased reflection of all currently available information. The expected returns implicit in the current price should reflect its risk.

Efficient Capital Markets Random walk hypothesis –the notion that stock prices changes are random and unpredictable. –Dealing with price movement over time Efficient market hypothesis –the notion that stock prices already fully reflect all available information. –The fair game model( specified time)

Efficient Capital Markets Investors will have an incentive to spend time and resources to analyze and uncover new information only if such activity is likely to generate high returns Competition among many well-backed, highly paid, aggressive analysts ensure stock prices ought to reflect available information regarding their proper levels

Alternative EMHs The weak-form EMH assumes that stock prices fully reflect all security-market information. –Including the historical of price, rates of return, trading volume data, and other market-generated information, such as block trades, short interest, odd-lot transactions.

Alternative EMHs The semistrong-form EMH asserts that security prices adjust rapidly to the release of all public information. –Public information includes all market and non-market information, such as earnings and dividend announcement, P/E ratios, D/P ratios, BV/MV ratios, product line, patent held, economic news, political news, etc.

Alternative EMHs The strong-form EMH contends that stock prices reflect all information from public and private sources relevant to the firm, including information available only to company insider. –It extends the assumption of efficient markets to assume perfect markets in which all information is cost-free and available to everyone at the same time.

Tests of the EMHs The difficulties of EMH tests –The magnitude issue:only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort. –The selection bias issue: we can not fairly evaluate the true ability of portfolio managers to generate winning stock market strategies.

Tests of the EMHs –The lucky event issue: any bet on a stock is simply a coin toss. If many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of bets.

Test of Weak-Form EMH Returns over short horizon –test of the efficiency of technical analysis –runs analysis of stock price –serial correlation in stock returns –filter rule analysis Returns over long horizon –long-term serial correlation

Test of Semisrtong-Form EHM D/P ratios analysis P/E effect The small-firm effect The January effect The neglected-firm and liquidity effect Market-to-book ratios Reversal effect The day-of-week effect

Test of Strong-Form EHM Inside information The value line enigma The market crash Mutual fund performance –performance across section –performance across time

Implications of the EMHs The EMH and Technical Analysis (TA) –TA is the search for recurring and predictable patterns in stock prices –The assumption of gradually response of stock prices to events is opposed to the notion of an efficient market –One should not expect abnormal returns through TA if EMH is true.

Implications of the EMHs The EMH & Fundamental Analysis(FA) –The EMH predicts that most FA adds little value. –One can make money only if his analysis is better than that of his competitors because the market price is expected already to reflect all commonly available information.

Implications of the EMHs The EMH & Portfolio Management(PM) –Only serious, time-consuming, and expensive technique are likely to generate the differential insight necessary to generate trading profit. –Active PM is largely wasted effort –Passive PM and Index fund

Implications of the EMHs The EMH and the role of PM –Portfolio selection: diversification v.s. Firm-specific risk –Tax consideration for specific client –Particular risk profile of the investor –Other factors: age, employment –Tailor the portfolio to above needs, rather than to attempt to beat the market.