Prepared by: GASTAR, Daneen Mitchelle G.

Efficient Capital Markets

• In an efficient capital market, security prices
adjust rapidly to the arrival of new information,
therefore the current prices of securities reflect
all information about the security
• Whether markets are efficient has been
extensively researched and remains
controversial
 Why Should Capital Markets
Be Efficient?
The premises of an efficient market
– 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
– Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
Conclusion: the expected returns implicit in the
current price of a security should reflect its risk
 Alternative
Efficient Market Hypotheses (EMH)
• Random Walk Hypothesis – changes in security
prices occur randomly
• Fair Game Model – current market price reflect all
available information about a security and the
expected return based upon this price is consistent
with its risk
• Efficient Market Hypothesis (EMH) - divided into
three sub-hypotheses depending on the
information set involved
 Random Walk and the EMH

• Actually stock prices follow a submartingale

– Expected price change is positive over time
– Positive trend and random around the trend
 Random Walk with Positive
Trend
Security
Prices

Time
Efficient Market Hypotheses (EMH)

• Weak-Form EMH - prices reflect all

security-market information
• Semistrong-form EMH - prices reflect all
public information
• Strong-form EMH - prices reflect all public
and private information
How might people earn using the news?
WEAK MARKET EFFICIENCY

1. Bob learns good

news.
2. At first, tells only friend
“Zai”
3. Zai buys the stock in
advance
4. CEO Pat announces
good news to public.
But, in a perfectly efficient market:

STRONG MARKET EFFICIENCY

AT THE SAME TIME

What if a market in a certain country
has something in between “ Strong”
and “Weak” market efficiency?
SEMI-STRONG MARKET EFFICIENCY
 Weak-Form EMH
• Current prices reflect all security-market
information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
• This implies that past rates of return and
other market data should have no
relationship with future rates of return
 Semistrong-Form EMH
• Current security prices reflect all public
information, including market and non-
market information
• This implies that decisions made on new
information after it is public should not lead
to above-average risk-adjusted profits from
those transactions
 Strong-Form EMH
• Stock prices fully reflect all information
from public and private sources
• This implies that no group of investors
should be able to consistently derive above-
average risk-adjusted rates of return
• This assumes perfect markets in which all
information is cost-free and available to
everyone at the same time
 Tests and Results of
Weak-Form EMH
• Statistical tests of independence between
rates of return
– Autocorrelation tests have mixed results
– Runs tests indicate randomness in prices
 Tests and Results of
Weak-Form EMH
• Comparison of trading rules to a buy-and-hold
policy is difficult because trading rules can be
complex and there are too many to test them all
– Filter rules yield above-average profits with small
filters, but only before taking into account
transactions costs
– Trading rule results have been mixed, and most have
not been able to beat a buy-and-hold policy
 Tests and Results of
Weak-Form EMH
• Testing constraints
– Use only publicly available data
– Include all transactions costs
– Adjust the results for risk
 Tests and Results of
Weak-Form EMH
• Results generally support the weak-form
EMH, but results are not unanimous
 Tests of the Semistrong Form of
Market Efficiency
Two sets of studies
• Time series analysis of returns or the cross
section distribution of returns for individual
stocks
• Event studies that examine how fast stock
prices adjust to specific significant
economic events
 Tests and Results of
Semistrong-Form EMH
• Test results should adjusted a security’s rate of
return for the rates of return of the overall market
during the period considered
Arit = Rit - Rmt
where:
Arit = abnormal rate of return on security i during
period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
 How Tests Are Structured
1. Examine prices and returns over time

-t 0 +t

Announcement Date
 Tests and Results of
Semistrong-Form EMH
• Quarterly Earnings Reports
– Large Standardized Unexpected Earnings
(SUEs) result in abnormal stock price changes,
with over 50% of the change happening after
the announcement
– Unexpected earnings can explain up to 80% of
stock drift over a time period
• These results suggest that the earnings
surprise is not instantaneously reflected in
security prices
 Tests and Results of
Semistrong-Form EMH

• The January Anomaly

– Stocks with negative returns during the prior
year had higher returns right after the first of
the year
– Tax selling toward the end of the year has been
mentioned as the reason for this phenomenon
– Such a seasonal pattern is inconsistent with the
EMH
 Tests and Results of
Semistrong-Form EMH
• Other calendar effects
– All the market’s cumulative advance occurs
during the first half of trading months
– Monday/weekend returns were significantly
negative
– For large firms, the negative Monday effect
occurred before the market opened (it was a
weekend effect), whereas for smaller firms,
most of the negative Monday effect occurred
during the day on Monday (it was a Monday
trading effect)
 Tests and Results of
Semistrong-Form EMH
• Predicting cross-sectional returns
– All securities should have equal risk-adjusted
returns
• Studies examine alternative measures of
size or quality as a tool to rank stocks in
terms of risk-adjusted returns
– These tests involve a joint hypothesis and are
dependent both on market efficiency and the
asset pricing model used
 Tests and Results of
Semistrong-Form EMH
• Price-earnings ratios and returns
– Low P/E stocks experienced superior risk-
adjusted results relative to the market, whereas
high P/E stocks had significantly inferior risk-
adjusted results
– Publicly available P/E ratios possess valuable
information regarding future returns
– This is inconsistent with semistrong efficiency
 Tests and Results of
Semistrong-Form EMH
• The size effect (total market value)
– Several studies have examined the impact of
size on the risk-adjusted rates of return
– The studies indicate that risk-adjusted returns
for extended periods indicate that the small
firms consistently experienced significantly
larger risk-adjusted returns than large firms
– Firm size is a major efficient market anomaly
– Could this have caused the P/E results
previously studied?
 Tests and Results of
Semistrong-Form EMH
• The P/E studies and size studies are dual
tests of the EMH and the CAPM
• Abnormal returns could occur because
either
– markets are inefficient or
– market model is not properly specified and
provides incorrect estimates of risk and
expected returns
 Tests and Results of
Semistrong-Form EMH
• Neglected Firms
– Firms divided by number of analysts following
a stock
– Small-firm effect was confirmed
– Neglected firm effect caused by lack of
information and limited institutional interest
– Neglected firm concept applied across size
classes
– Another study contradicted the above results
 Tests and Results of
Semistrong-Form EMH
• Ratio of Book Value of a firm’s Equity to Market
Value of its equity
– Significant positive relationship found between
current values for this ratio and future stock
returns
– Results inconsistent with the EMH
• Size and BV/MV dominate other ratios such as
E/P ratio or leverage
• This combination only works during expansive
monetary policy
 Tests and Results of
Semistrong-Form EMH
• Firm size has emerged as a major predictor
of future returns
• This is an anomaly in the efficient markets
literature
• Attempts to explain the size anomaly in
terms of superior risk measurements,
transactions costs, analysts attention,
trading activity, and differential information
have not succeeded
 Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns, and earnings surprises
• This also included cross-sectional predictors
such as size, the BV/MV ratio (when there
is expansive monetary policy), E/P ratios,
and neglected firms.
 Tests and Results of
Strong-Form EMH
• Strong-form EMH contends that stock
prices fully reflect all information, both
public and private
• This implies that no group of investors has
access to private information that will allow
them to consistently earn above-average
profits
 Testing Groups of Investors
• Corporate insiders
• Stock exchange specialists
• Security analysts
• Professional money managers
 Corporate Insider Trading
• Corporate insiders include major corporate
officers, directors, and owners of 10% or
more of any equity class of securities
• Insiders must report to the SEC each month
on their transactions in the stock of the firm
for which they are insiders
• These insider trades are made public about
six weeks later and allowed to be studied
 Corporate Insider Trading
• Corporate insiders generally experience
above-average profits especially on
purchase transaction
• This implies that many insiders had private
information from which they derived above-
average returns on their company stock
 Corporate Insider Trading
• Studies showed that public investors who
traded with the insiders based on announced
transactions would have enjoyed excess
risk-adjusted returns (after commissions),
but the markets now seem to have
eliminated this inefficiency (soon after it
was discovered)
 Corporate Insider Trading
• Other studies indicate that you can increase
returns from using insider trading
information by combining it with key
financial ratios and considering what group
of insiders is doing the buying and selling
 Professional Money Managers
• Trained professionals, working full time at
investment management
• If any investor can achieve above-average
returns, it should be this group
• If any non-insider can obtain inside
information, it would be this group due to
the extensive management interviews that
they conduct
 Performance of
Professional Money Managers
• Most tests examine mutual funds
• New tests also examine trust departments,
insurance companies, and investment
advisors
• Risk-adjusted, after expenses, returns of
mutual funds generally show that most
funds did not match aggregate market
performance
 Conclusions Regarding the
Strong-Form EMH
• Mixed results, but much support
• Tests for corporate insiders and stock
exchange specialists do not support the
hypothesis (Both groups seem to have
monopolistic access to important
information and use it to derive above-
average returns)
 Conclusions Regarding the
Strong-Form EMH
• Tests results for analysts are concentrated on
Value Line rankings
– Results have changed over time
– Currently tend to support EMH
• Individual analyst recommendations seem to
contain significant information
• Performance of professional money managers
seem to provide support for strong-form EMH