1. Chapter 9
Market Efficiency

2. Chapter Summary
Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency.
The Efficient Market Hypothesis
Empirical Tests of Market Efficiency

3. Efficient Market Hypothesis (EMH)
Do security prices reflect information ?
Why look at market efficiency
Implications for business and corporate finance
Implications for investment

4. Random Walk and the EMH Random Walk - stock price change unpredictably
Actually stock prices follow a submartingale
Expected price is positive over time
Positive trend and random around the trend

5. Random Walk with Positive Trend
Security
Prices
Time

6. Random Price Changes Why are price changes random?
Prices react to information
Flow of information is random
Therefore, price changes are random

7. EMH and Competition
Stock prices fully and accurately reflect publicly available information
Once information becomes available, market participants analyze it
Competition assures prices reflect information

8. Forms of the EMH Weak –all past market trading information
Semi-strong –all publicly available information regarding the prospects of a firm
Strong – all information relevant to the firm

9. Types of Stock Analysis
Technical Analysis - using prices and volume information to predict future prices
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and accounting information to predict stock prices
Semi strong form efficiency & fundamental analysis

10. Implications of Efficiency for Active or Passive Management
Active Management
Security analysis
Timing
Passive Management
Buy and Hold
Index Funds

11. Market Efficiency and Portfolio Management
Even if the market is efficient a role exists for portfolio management
Diversification
Appropriate risk level
Tax considerations

12. Summary Reminder
Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency.
The Efficient Market Hypothesis
Empirical Tests of Market Efficiency

13. Empirical Tests of Market Efficiency
Event studies
Assessing performance of professional managers
Testing some trading rule

14. How Tests Are Structured
1. Examine prices and returns over time +t -t
Announcement Date

15. How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they are abnormal
Market Model approach
a. Rt = a + bRmt + et
(Expected Return)
b. Excess Return = (Actual - Expected)
et = Actual - (at + btRmt)

16. How Tests Are Structured (cont’d)
Market Model approach
c. Cumulate the excess returns over time: +t -t

17. Issues in Examining the Results
Magnitude Issue
Selection Bias Issue
Lucky Event Issue
Possible Model Misspecification

18. What Does the Evidence Show?
Technical Analysis
Short horizon
Long horizon
Fundamental Analysis
Anomalies Exist

19. Anomalies Small Firm Effect (January Effect) Neglected Firm
Book to Market Ratios
Reversals
Note: above anomalies may actually be risk-premiums

20. Anomalies (cont.) Weekend effect Inside information
Post-Earnings Announcement Drift

21. Explanations of Anomalies
May be risk premiums
Behavioral explanations
Forecasting errors
Overconfidence
Regret avoidance
Framing and mental accounting

22. Mutual Fund and Professional Managers’ Performance
Some evidence of persistent positive and negative performance
Potential measurement error for benchmark returns
Style changes
May be risk premiums
Superstar phenomenon