1. Chapter 10 The Efficiency of Financial Markets
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

2. Learning Objectives
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

3. Different Concepts of Market Efficiency
allocative efficiency – the efficiency with which the capital markets allocate the scarce capital funds to the most productive uses
in an ideal world, capital would be allocated to the firms that can achieve the best marginal returns
operational efficiency – the cost efficiency of the financial markets and financial institutions described in terms of charges to investors
ideally, the costs of raising capital would be minimized and viable long-term projects would be able to raise capital as easily as short-term ones. Investors would face minimal transaction charges as financial institutions compete for their business.
informational efficiency – the extent to which market prices of securities fully incorporate information and react to changes in information so that abnormal returns cannot be made on a consistent basis
the levels of information efficiency vary
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

4. Three Levels of Efficiency
an efficient market was first defined by Eugene Fama (1970) as one “in which prices always “fully reflect” available information”
weak-form efficiency
the current prices of securities instantly and fully reflect all information of the past history of securities prices
semi-strong-form efficiency
the current prices of securities instantly and fully reflect all publicly available information
strong-form efficiency
the current prices of securities instantly and fully reflect all information, both public y available information and privately held information held by company insiders
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

5. Efficiency Hypothesis
efficient market hypothesis (EMH) – a theory that says security prices reflect all available information thus making it difficult for investors to make abnormal returns
the concept is very similar to the idea of a ‘fair game’: there is no systematic difference between the actual return on the game and the expected return on the game
if EMH holds then the expected rate of return one period ahead will be the same as the actual return today and the return on a security i can be formalised by a random walk:
where the error term ut+1 is
has an expected value of zero
independent of the expected rate of return on a security
is not predictable on the basis of any information available at time t
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

6. Implications of Efficient Market Hypothesis
weak-form EMH: the forecasts of chartists and technical analysts will not be profitable on average
chartist – a person that uses chart patterns on past prices of a security to forecast future price changes in financial markets
technical analyst – a person that uses statistical analysis of past price behaviour, sometimes supplemented with volumes traded, to predict future price changes in financial markets
semi-strong form EMH: the forecasts of investment and research analysts yield no excess returns
investment analysts use public information such as company reports, company announcements, industry reports and economic forecasts, they share a belief that it is the prospective for economic and company fundamentals that can predict future security prices
strong form EMH: even those with access to privileged inside information will not be able to profit from that information since it is already incorporated into a security’s price
if this theory was to hold there would be no need for securities houses to maintain Chinese walls – barriers put to prevent conflicts of interest within the institution
If this theory held then there would be no profits to be made from “insider dealing.”
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

7. Fund Management active fund management
the use of fund manager’s skills and experience to buy and sell selected securities
essentially, it is the process of looking for ‘undervalued’ and ‘overvalued’ securities, and shifting the composition of a portfolio accordingly
can involve frequent buying and selling of shares and high transaction charges for the fund
passive fund management
a strategy of buying and holding shares, usually to track a market index
the idea is to select a portfolio of securities with the desired risk characteristics
the underlying belief is that the EMH holds so there is no need to engage in active fund management
leads to very low transaction charges

8. Tests for Weak EMH tests for a random walk price model
idea: the best forecast of the future price of a security is the current price, and adding details of past security price movements will be of no use in predicting the future course of the security’s price
evidence: strong empirical support – share prices do indeed follow a random walk, or a random walk with a positive drift component
filter-rule tests
idea: it should not be possible to make abnormal return from looking at past prices; based on recent price movements the filter rules are designed to catch significant trends in securities prices
issue: it is unclear what should be the appropriate filer size
evidence: whatever the size of filter is chosen, there are no excess profits to be made compared to a simple buy-and-hold strategy once due allowance has been made for transaction costs
other statistical tests
run tests
idea: the runs with too many consecutive price increases or decreases or repeating patterns should not appear more or less frequently than in a set of random numbers
evidence: modest support for weak EMH
relatively sophisticated time-series techniques

9. Filter Rule Tests

10. Data Anomalies the day-of-the-week effect January effect
despite the strong evidence that stock price movements are generally random, a few data anomalies have been uncovered that cause to question whether share prices really incorporate all historical data
the day-of-the-week effect
share price tend to fall on Mondays and rise on Fridays
this result does not necessarily have an economic significance
more recent studies found that this effect had disappeared (consistent with EMH, traders sell on Friday and buy on Monday to profit from this effect)
January effect
returns on stocks in January are relatively higher, also small companies significantly outperform the market as a whole in January
this effect may represents the result of ‘window-dressing’ by fund managers at the end of the year, that is, a switch to better-known stocks at the end of the year to inflate the performance of the portfolio
the winner-loser problem
investors tend to over-react to moving share prices
‘winners’ seem to do better than ‘losers’ in the seven months following the quarterly earnings announcements, but do significantly worse at the 8-36-month horizon
Keith Pilbeam ©: Finance and Financial Markets 4th Edition
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

11. Tests for Semi-Strong EMH
the public information includes earnings data, changes in dividend policy, announcement of stock split (replacement of existing shares with a greater number of shares to lower the price), news of takeover bids, newspaper column tips, etc.
the market will only react to the ‘news’ element of information
to test adequately whether the share price incorporate public information careful account needs to be taken of the risk characteristics of the shares analyzed, thus semi-strong EMH requires joint tests
event study – analysis of the impact of a particular type of announcement on the share prices of a group of firms for a period prior to the announcement and after the announcement
idea: the newly released information should lead to a sharp change in the share price upon the announcement and continue to trade at the new equilibrium level thereafter until further news
evidence: empirical studies conducted for various types of announcements generally support semi-strong EMH
as market over-reacts or under-reacts to the news, the period of adjustment normally follows the announcement while the price achieves fundamental its value level
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

12. Event Study: the Impact of News
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

13. Data Anomalies the size effect the price-earnings effect
there are some anomalies that pose the challenge to the semi-strong form of efficiency as revealed in numerous studies:
the size effect
the excess return from holding the sticks in the lowest quintile (made up of the smallest quoted companies) compared to those of the top quintile (representing the largest firms) was significantly higher
the effect was as significant as firms’ betas in explaining excess returns
the price-earnings effect
the return on company stocks with low price-earnings ratios is significantly higher than the returns on companies with relatively high P/E ratios
the empirical evidence shows that smaller companies are not riskier as measured by their betas
the earnings-announcement effect
the stock prices start moving in anticipation prior to the announcement date suggesting that a degree of insider knowledge is being priced into the stock
there were significant and predictable returns to be made in the 90 days following the announcement – therefore not all news are priced into the market at the time of announcement
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

14. Stockmarket Crashes Problem Arguments for EMH
Jan-Oct 1987: most stock indices around the world experienced a bull market
the UK market was up 75% in the year
the US market up 30%
the Hong Kong index up 70%
19 Oct 1987 – ‘black Monday’: a dramatic collapse
the US market fell by 23% that day
the UK market fell 30% over 3 days
the Hong Kong index fell 50% over the week
speculative bubble – a term used to describe fast dramatic price rises of shares or something else that is likely to prove unsustainable
Arguments for EMH
1.rational bubble – a speculative bubble in which many speculators believe that a security or asset is significantly overpriced and likely to collapse in price at some time in the future but they continue to buy the overpriced security so long as expected rise is sufficient to compensate for risk of an eventual collapse of the price.
2. stock market crashes - can still be consistent with market efficiency if sufficient bad news arrives to alter future expectations, enough to justify sharp lower stock prices
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

15. Tests for Strong EMH
Testing for strong-form efficiency is much more challenging since it is difficult to find a good proxy for inside information
directors’ share purchases
idea: all such sales and purchases have to registered publicly and directors and managers are not permitted to trade on price sensitive information; one would expect insiders to purchase shares before any price rises and sell shares in advance of price falls
evidence: empirical results contradict strong form EMH – managers and directors earn excess returns from their trades
analysts’ forecasts
idea: analysts presumably have a greater access to inside information about a company and their tips are not necessarily disseminated to wider public
evidence: there is a positive correlation between the analysts’ forecasts of excess return and the actual excess return through acting on the recommendations which again reject the strong form efficient market hypothesis
Keith Pilbeam ©: Finance and Financial Markets 4th Edition