Market Efficiency

Dr. Madhuri Malhotra

 A Startling Discovery: Random
Price Changes
• The concept of efficient capital markets stemmed from a chance discovery. In
1953, Maurice Kendall, a British statistician, presented a controversial paper
to the Royal Statistical Society on the behavior of stock and commodity
prices.
2

• Kendall had expected to find regular price cycles, but to his surprise they did
not seem to exist.
• Each series appeared to be “a ‘wandering’ one.
• The prices of stocks and commodities seemed to follow a random walk.
price changes are
independent of one
another just as the gains
and losses in the coin-
tossing game are
independent.
 Random walk
• You should see now why prices in competitive markets must follow a
random walk.
• If past price changes could be used to predict future price changes, investors
could make easy profits.
• But in competitive markets, there are no such free lunches
• As investors try to take advantage of any information in past prices, prices
adjust immediately until the superior profits from studying price movements
disappear. As a result, all the information in past prices will be reflected in
today’s stock price, not tomorrow’s.
• Patterns in prices will no longer exist, and price changes in one period will
be independent of changes in the next. In other words, the share price will
follow a random walk.
Efficient market Hypothesis
• A market in which stock prices fully reflect
information is termed an efficient market. Economists
define three levels of market efficiency, which are
distinguished by the degree of information reflected in
security prices.
What Is the Efficient Market Hypothesis (EMH)

share prices reflect all

information.
IS IT SO ??
 Efficient Market Hypothesis

• PROPOUNDED BY – EUGENE, F. FAMA

• STOCK PRICES REFLECT ALL AVAILABLE
INFORMATION !!!
• WHAT ABOUT INSIDER TRADING ?
 MAIN FINDINGS !!!
• Fundamental Analysis Is Useless Since All the available information(book
value , market value etc) are publicly available and its incorporated in the
stock prices.

• Technical analysis is useless as the past prices cannot be used to predict

the future price of stock and the randomness
 Fundamental analysis
• Fundamental analysis is a method of determining a stock's real or "fair market"
value.
• Fundamental analysts search for stocks currently trading at prices higher or lower
than their real value.
• If the fair market value is higher than the market price, the stock is deemed
undervalued, and a buy recommendation is given.
• If the fair market value is lower than the market price, the stock is deemed
overvalued, and the recommendation might be not to buy or to sell if the stock is
held.
• In contrast, technical analysts favor studying the historical price trends of the stock
to predict short-term future trends.
 Fundamental Analysis
• Fundamental analysis is usually done from a macro to micro perspective
to identify securities that are not correctly priced by the market.
• Analysts typically study:
1. The overall state of the economy
2. The strength of the specific industry
3. The financial performance of the company issuing the stock
 Intrinsic Value

• the value reflected from the company's fundamental data is more likely
to be closer to the true value of the stock.
Fundamental analysis use

• By focusing on a particular business, an investor can estimate the

intrinsic value of a firm and find opportunities to buy at a discount or
sell at a premium. The investment will pay off when the market catches
up to the fundamentals.
Efficient Market theory
• EMH says over the long run stock prices reflect the true value.
• Does this hold good ?
Efficient Market theory
“Security prices accurately reflect available information, and respond
rapidly to new information as soon as it becomes available”
………………………………………………….Richard Brealey & Stewart Myers,
Principles of Corporate Finance, 1996
 EMH

• If new information becomes known about a particular company, how

quickly do market participants find about the information? And buy and
sell the securities of the company on the basis of the information ?
 Semi Strong Form Efficiency
• Semi-strong efficiency
• This form of EMH implies that all public information is calculated into a
stock's current share price.
• Neither technical nor fundamental analysis can be used to achieve
superior gains.

Monday, December 11, 2023

How to estimate whether market is semi-strong
form efficient?
• Event Study

Monday, December 11, 2023

 • Studies of the semi-strong form of the efficient markets
hypothesis can be categorized as

• Tests of the speed of adjustment of prices to new

information. The principal research tool in this area is the
event study.
• An event study averages the cumulative performance of
stocks over time, from a specified number of time periods
before an event to a specified number of periods after.

• Performance for each stock is measured after adjusting for

market-wide movements in security prices.

• The first event study was undertaken by Fama, Fisher, Jensen

and Roll (1969), though the first to be published was by Ball
and Brown (1968).

Monday, December 11, 2023

Overview of event Studies
1. Event studies examine the effect of some
event or set of events on the value of assets

2.Unexpectedly large increase or decrease

Monday, December 11, 2023

An event can be:
• What makes and event? - Some change, development,
announcement that may produce a relatively large change in the
price of the asset over some period.

1. Stock splits
2. Earning announcements
3. Merger or takeover announcements
4. Regulatory change
5. any other announcement or event
Monday, December 11, 2023
Procedure
• Define an event window – a period over which the event occurs
• Define an estimation window – a period over which parameters are
estimated

Monday, December 11, 2023

 (T0...T1] is estimation window
(T1...T2] is event window
(T2...T3] is post-event window

Monday, December 11, 2023

How to estimate return due to event
• Calculate Returns of the firms during the event
window using the standard formula

Today’s price – yesterday’s price

_________________________________
Yesterday’s price

Monday, December 11, 2023

• Estimate returns during the event window
• Estimate market index returns

• Return during the event window minus market index returns is

abnormal returns .

Monday, December 11, 2023

Market adjusted Returns Method to estimate
Abnormal Returns
• ARit = Rit – Rmt

ARit is the abnormal returns

Rit is the firm’s returns
Rmt is the market Index Returns

• This method allows for general market movements, but assumes each
firm has same average return and risk characteristics as market as a
whole
Monday, December 11, 2023
Aggregation of Abnormal Returns
Aggregate returns over time and across Firms
Over time : aggregate across different time periods to see if effect
develops over time
Across firms : Aggregate across firms in the sample.

Monday, December 11, 2023

Aggregate over time

CARi is Cumulative Abnormal Return for firm I Under the

null hypothesis of no abnormal return, the abnormal return
is zero.

The term CAR(-5, 0) means the CAR calculated from five days
before the announcement to the day of announcement.

Monday, December 11, 2023

CAPM and APT: what they say ?
• These theories describe the structure of the prices of financial assets
• Explain about the relationship between the return and the risk
(beta)of a security.

• Market efficiency theory focuses on “ How the market securities in

relation to its structure”.
Efficient Market Theory
“Security prices accurately reflect available information, and respond
rapidly to new information as soon as it becomes available”
………………………………………………….Richard Brealey & Stewart Myers,
Principles of Corporate Finance, 1996
EMH
• If new information becomes known about a particular company, how
quickly do market participants find about the information? And buy
and sell the securities of the company on the basis of the
information ?
Forms of market efficiency !!!

Insider information / private

Strong information

Public information
Semi strong

Past prices

Weak
EMH explained
• https://www.youtube.com/watch?v=e-BoCacmkM8

• https://www.youtube.com/watch?v=kJzfKuiBK50
 Implications of market efficiency

• No group of investors should be able to consistently beat the market in an

efficient market
• Equity research and valuation would be a costly task that provided no benefits.
• The stock price is equal to the fundamental or intrinsic value.
• Financial assets cannot be overvalued and undervalued
• They are always traded at their fair value
Apprehensions regarding MARKET EFFICIENCY

Anomalies !!!! What they

are !!!
 What Is an Anomaly?

• In economics and finance, an anomaly is when the actual result under a

given set of assumptions is different from the expected result predicted
by a model.
• An anomaly provides evidence that a given assumption or model does
not hold up in practice.
ANOMALIES
• Many authors such as Grossman and Stilgitz (1980) and Werner and
Thaler (1985) market efficiency tests and identified certain
anomalies----which led to many apprehensions regarding EMH.
 Financial market anomalies

• Market anomalies are the usual occurrence or abnormality in smooth

pattern of stock market.
• They are cross sectional and time series patterns in stock returns that are
not possible to be predicted by financial theories.
• The term anomaly was put forth by Kuhn in 1970.
 Financial market anomalies
• Financial market anomaly is a situation where in the performance of the stock
deviate substantially from established assumptions and are not able to be
explained by efficient market hypothesis.

• These anomalies could earn large profits.

 Types of Anomalies

• Fundamental anomalies
• Technical Anomalies
• Calendar Anomalies
 Value anomalies

Fundamental anomalies
Low price to book

High dividend
yield

Low price to sales

Low price to
earnings
 Fundamental Anomalies
• Value Anomalies: overestimation of future earnings of the
growth companies and underestimation of future
earnings of value company.
• This anomaly stems from the feeling that stocks that have
a low price to book ratio usually generate more returns
than stocks having a high book to market ratio.
 High dividend yield
• Stocks with high dividend yield have a tendency to outperform the
market and generate better returns.
Low price to sales

• Price to sales ratio is an indicator of the value placed on the sales or

revenues
• Low rate indicates ------undervaluation
 Low price to earnings

• The stocks with low price to earning ratio are likely to generate more
returns and outperform the market as against the stocks with high price to
earning ratio.
 Technical
Anomalies
Investors will not be
able to beat the
market and abnormal
returns by using
technical analysis.
Calendar anomalies
Monday weekend
effect

Month of the year

effect –January effect

Turn of the month

Effect
Monday / week end effect
• The Monday effect is a theory which states that returns on the stock
market on Mondays will follow the prevailing trend from the
previous Friday.
• Therefore, if the market was up on Friday, it should continue
through the weekend and, come Monday, resume its rise.
• The Monday effect is also known as the “weekend effect”.
 January Effect

• The January Effect is a perceived seasonal increase in stock prices during

the month of January.
• investors use year-end cash bonuses to purchase investments the following
month.
 Types of Anomalies

• Fundamental anomalies
• Technical Anomalies
• Calendar Anomalies
Exercise: to be done

• Take any 2 stocks of your choice. Check if any type of

ANOMALY holds true for that particular stock. Comment
on the future growth prospects of the companies
• Identify 2 growth stocks. Comment on the reasons why have you classified it
as a growth stock?
• You can download data from the BSE website. Example is given hereunder
• https://www.bseindia.com/markets/equity/EQReports/StockPrcHistori.aspx?
expandable=7&scripcode=500247&flag=sp&Submit=G