1. The Efficient Market Hypothesis (EMH)
Understand the evidence for and against market efficiency
Understand the implications of market efficiency for investing and financing decisions

2. Efficient Capital Markets
An efficient capital market is one in which stock prices fully reflect all available information.
The Efficient Markets Hypothesis (EMH) has implications for investors and firms.
Since information is reflected in security prices quickly, knowing information when it is released does an investor no good.
Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.
Market efficiency is a funny thing:
Markets are efficient precisely because there are lots of well-paid, well-financed, and smart security analysts who don’t believe that the markets are efficient…and their actions make the market efficient!
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EMH

3. Review
The EMH says that trying to find patterns in stock prices or trying to find “winners” is a waste of time
The possibility of making excess profits in the stock markets is as rare as finding a sum of money on the street
If a sum of money is lost it will be picked up by somebody very quickly
In the very same way an opportunity to make excess profits will be taken up very quickly, so that no such opportunity will exist for long
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4. Forms of market efficiency
There are three forms of market efficiency. Markets are either:
Weak form efficient
Semi-strong form efficient
Strong form efficient
The distinction between these three forms of market efficiency depends on the level of information incorporated into the stock price
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5. Weak form efficiency
If markets were weak form efficient, then all historical information would be reflected in the stock price
it is not possible to make excess returns by using historical information such as company reports, past prices, or any other information that is readily available on the company
Investor would no be able to benefit from this type of information because it is readily available and doesn’t cost very much
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6. Weak Form
Selecting stocks based on historical information would be of no use to investors.
The fact that a share price might have risen for the past four days, does not give us any information about how the stock price will perform on the fifth day
Analysts who plot past price movements are called “Chartists”
If you believe that weak form efficiency exists, then you believe that chartists are wasting their time
E.G. If a chartist finds a pattern which shows that if a stock price falls for three consecutive days and then rises by 5% on the fourth day, investors could make money by buying stock that fall for three consecutive days
However no investor would sell a stock that had fallen for three consecutive days if she thinks that it will rise in price the following day
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7. Weak Form
In fact if the share price is €10 on the third day and if it is expected to rise by 5% on the fourth day, the share price would probably rise to €10.50 on the third day, which will eliminate the opportunity for excess profits
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8. Why Technical Analysis Fails
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.
Sell
Sell
Buy
Buy
Time
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9. Semi-strong form efficiency
Markets are said to be semi-strong form efficient if no excess returns can be made using publicly available information.
The semi-strong form of the EMH indicates that market prices reflect all publicly available information.
Excess returns cannot be earned by looking at annual reports or any other published data because all such information, good or bad would have been incorporated into the share price when the information became available
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10. Semi Strong Form
However, any information that is not made available to the public such as that held by company insiders (e.g. directors) can be used to earn excess returns under semi-strong form efficiency.
In addition, stock prices will be affected by information that becomes available if the information is different to what was expected
For example, if the company reports a 10% increase in after-tax earnings, the share price won’t be affected by this news if that is what the market was expecting
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11. Semi Strong Form
On the other hand, if the market was expecting an earnings increase of an amount greater than 10%, then the share price will drop and the share price will rise if the increase in earnings was greater than 10%
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12. Strong form efficiency
In strong form efficient markets, all information, public and private is reflected in the share price
Incorporating all private information would seem to be difficult
Some information, like a company’s sales figures may only be known to the directors of the company
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13. Strong Form
If this information is not divulged, then it does not seem possible for the market to incorporate this information into share price.
It might be possible to observe if there was any buying or selling of company shares by insiders acting on privately held information
If a strong form of market efficiency exists, even insider information cannot be used to earn excess returns
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14. Efficient Markets: the Evidence
In the years that followed Maurice Kendall’s discovery, financial journals were packed with tests of the EMH
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15. Testing Weak Form To test weak form efficiency
Researchers measured the profitability of some of the trading rules used by technical analysts, who claim to find patterns in security prices
They also used statistical tests
IT APPEARS THAT THROUGHOUT THE WORLD THERE ARE FEW PATTERNS IN WEEK-TO-WEEK RETURNS
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16. Testing Semi Strong To test the semi-strong form
Researchers have measured how rapidly security prices respond to different types of news, such as dividend or earnings announcements, news of takeovers, or macroeconomic news
Any new publicly available information gets instantaneously incorporated into security prices and there is no chance to profit from the information
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17. Testing Semi Strong
The type of methods used by investment analysts vary in their degree of sophistication:
Some prefer to use simple models based upon looking at data such as E.P.S and Gordan’s growth model, others resort to complex econometric models
The semi-strong form of market efficiency leaves open the possibility for those with privileged inside information to make abnormal profits
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18. Testing Strong Form To test the strong-form
The strong form of market efficiency implies that 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
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19. Testing Strong Form
If it were to hold, then there would be no need for security houses to have “Chinese walls” whereby price-sensitive information from one part of the business is kept from the dealing/brokerage arm of the organization, and there would also be no need for government’s to have “insider trading laws”
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20. The Evidence
The record on the EMH is extensive, and in large measure it is reassuring to advocates of the efficiency of markets.
Studies fall into three broad categories:
Are changes in stock prices random? Are there profitable “trading rules”?
Event studies: does the market quickly and accurately respond to new information?
The record of professionally managed investment firms.
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21. Are Stock Prices Changes Random?
Can we really tell?
Many psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness.
People claiming to see patterns in stock price movements are probably seeing optical illusions.
A matter of degree
Even if we can spot patterns, we need to have returns that beat our transactions costs.
Random stock price changes support weak-form efficiency.
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22. Event Studies: How Tests Are Structured
Event Studies are one type of test of the semi-strong form of market efficiency.
This form of the EMH implies that prices should reflect all publicly available information.
To test this, event studies examine prices and returns over time—particularly around the arrival of new information.
Test for evidence of under reaction, overreaction, early reaction, delayed reaction around the event.
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23. How Tests Are Structured (cont.)
Returns are adjusted to determine if they are abnormal by taking into account what the rest of the market did that day.
The Abnormal Return on a given stock for a particular day can be calculated by subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day:
AR= R – RM
The abnormal return can be calculated using the Market Model approach:
AR= R – (a + bRM)
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24. Event Studies: Dividend Omissions
Efficient market response to “bad news”
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997)
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25. Event Study Results
Over the years, event study methodology has been applied to a large number of events including:
Dividend increases and decreases
Earnings announcements
Mergers
Capital Spending
New Issues of Stock
The studies generally support the view that the market is semistrong-from efficient.
In fact, the studies suggest that markets may even have some foresight into the future—in other words, news tends to leak out in advance of public announcements.
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26. Issues in Examining the Results
Magnitude Issue
Selection Bias Issue
Lucky Event Issue
Possible Model Misspecification
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27. The Strong Form of the EMH
One group of studies of strong-form market efficiency investigates insider trading.
A number of studies support the view that insider trading is abnormally profitable.
Thus, strong-form efficiency does not seem to be substantiated by the evidence.
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28. Views Contrary to Market Efficiency
Stock Market Crash of 1987
The market dropped between 20 percent and 25 percent on a Monday following a weekend during which little surprising information was released.
Temporal Anomalies
Turn of the year, —month, —week.
Speculative Bubbles
Sometimes a crowd of investors can behave as a single squirrel.
The authoritative and entertaining book about speculative bubbles is “Extraordinary Popular Delusion and the Madness of Crowds” by John Mackay
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29. Empirical Challenges to Market Efficiency (anomalies)
Crashes
On October 19, 1987 the stock market dropped between 20 and 25 percent on a Monday following a weekend during which little surprising news was released.
A drop of this magnitude for no apparent reason is inconsistent with market efficiency.
Bubbles
Consider the tech stock bubble of the late 1990s.
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30. Reviewing the Differences
Financial Economists have sorted themselves into three camps:
Market efficiency
Behavioral finance
Those that admit that they don’t know
This is perhaps the most contentious area in the field.
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31. Implications for Corporate Finance
Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return.
Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it.
Firms should expect to receive the fair value for securities that they sell.
Fair means that the price they receive for the securities they issue is the present value.
Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets.
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32. Implications for Corporate Finance
The EMH has three implications for corporate finance:
The price of a company’s stock cannot be affected by a change in accounting.
Financial managers cannot “time” issues of stocks and bonds using publicly available information.
A firm can sell as many shares of stocks or bonds as it desires without depressing prices.
There is conflicting empirical evidence on all three points.
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33. Why Doesn’t Everybody Believe the EMH?
There are optical illusions, mirages, and apparent patterns in charts of stock market returns.
The truth is less interesting.
There is some evidence against market efficiency:
Seasonality
Small versus Large stocks
Value versus growth stocks
The tests of market efficiency are weak.
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34. Some Common Misconceptions
Much of the criticism of the EMH has been based on a misunderstanding of the hypothesis says and does not say.
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35. What the EMH Does and Does NOT Say
Investors can throw darts to select stocks.
This is almost, but not quite, true.
An investor must still decide how risky a portfolio he wants based on risk aversion and the level of expected return.
Prices are random or uncaused.
Prices reflect information.
The price CHANGE is driven by new information, which by definition arrives randomly.
Therefore, financial managers cannot “time” stock and bond sales.
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36. Summary and Conclusions
An efficient market incorporates information in security prices.
There are three forms of the EMH:
Weak-Form EMH
Security prices reflect past price data.
Semistrong-Form EMH
Security prices reflect publicly available information.
Strong-Form EMH
Security prices reflect all information.
There is abundant evidence for the first two forms of the EMH.
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