1. The Theory of Stock Market Efficiency: Accomplishments and Limitations
Haoyue Guan Yulu Hou Longyu Chen
Group 2
Fin 680
Introduction: Chen

2. Summary Market efficiency has been researched for over 50 years.
Basic idea of market efficiency: competition causes information to change; reflected in stock price quickly.
The research of market efficiency helped develop many financial theories, which has accomplishments and limitations.
Rain

3. The idea that markets are “efficient”
Eugene Fama defined “market efficiency” first in 1965 as:
“A market where there are large numbers of rational, profit- maximizers actively competing, with each trying to predict future market value of individual securities, and where important current information is almost freely available to all participants. On the average, competition will cause the full effects of full information on intrinsic values to be reflected “instantaneously” in actual price.”
Rain

4. Accomplishments of the theory of stock market efficiency
Event time (by FFJR in 1969): stock market reaction to stock behavior.
Usually, stock split is good news to investors. Studies show 72% of splitting firms announced dividend increases in the year after splitting.
New public stock associated with 3% immediate drop of price.
Rain

5. Influencing the climate for other financial economic theories
Early work in market efficiency helped developed three financial theories:
The Miller-Modigliani theories of corporate financial theory in 1958
CAPM in 1964
Black-Scholes option pricing model in 1973
Rain

6. Limitation in the theory of efficient markets
Failure to explain certain aspects of share price behavior
Flaw in efficiency as a model of markets
Problems in testing the efficiency model
Rose

7. Empirical Anomalies Price overreactions
Excess volatility (Robert Shiller)
Price underreaction to earnings
The failure of CAPM to explain returns
[E(R) = Rf + B (Rm - Rf)]
The explanatory power of Non-CAPM factors
Seasonal patterns (weekend effect)
Rose

8. Flaw in efficiency as a model of markets
Heterogeneous information and beliefs (F.A. Hayek, 1945)
A brief digression on the role of security analysts
Failure to consider transactions costs (Michael Jensen, 1989)
Market microstructure effects
Rose

9. Problems in testing “efficiency” as a model of stock markets
E(R) = Rf + B (Rm - Rf)
Change in riskless rates and risk premiums
Trends in rates and market risk premiums
Changes in betas
Seasonal patterns in betas
Chen

10. Is “Behavioral” finance the answer?
----- The limitations of efficient markets theory
Behavioralists argue that stock price “corrections” and cycles reflect systematic biases in how investors use information. Investors are said to place too much weight on current information, focusing myopically on short-term earnings.
The author doesn’t think so.
The profit opportunities created by such alleged investor myopia seem grossly inconsistent with competitive markets.
Behavioral finance has anomalies of its own.
Chen

11. Concluding observations
Are stock market efficient? Yes and no.
The research provides insights into stock price behavior that were previously unimaginable.
As research has come to show, the theory of efficient markets is, like all theories, an imperfect and limited way of viewing stock markets. The issue will be impossible to solve conclusively while there are so many binding limitations to the asset pricing models that underlie empirical tests of market efficiency.
Chen