Chp 11 efficient market hypothesis by mahmudul
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The document discusses the evolution and different forms of the efficient market hypothesis (EMH). It begins by explaining Maurice Kendall's 1953 study that found stock prices move randomly without predictable patterns. This challenged the notion that markets are irrational, and instead suggested markets are efficient. The document then discusses how the EMH developed, with the idea that markets quickly incorporate all available information into stock prices, making them unpredictable. It outlines Fama's three forms of the EMH based on the information reflected in prices. The implications of EMH for technical analysis, fundamental analysis, and active vs passive portfolio management are also discussed. Finally, empirical tests and evidence related to market efficiency are reviewed.
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Chp 11 efficient market hypothesis by mahmudul
- 1. CHAPTER-11 The Efficient Market Hypothesis Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 2. Evolution of The Efficient Market Hypothesis ■ In 1950s, Business cycle theorists felt that tracing the evolution of several economic variables over time would clarify and predict the progress of the economy through boom and bust periods. A natural candidate for analysis was the behavior of stock market prices over time. Assuming that stock prices reflect the prospects of the firm, recurrent patterns of peaks and troughs uneconomic performance ought to show up in those prices. ■ Maurice Kendall examined this proposition in 1953. He found to his great surprise that he could identify no predictable patterns in stock prices. Prices seemed to evolve randomly. They were as likely to go up as they were to go down on any particular day, regardless of past performance. The data provided no way to predict price movements. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 3. Evolution of The Efficient Market Hypothesis ■ At first Kendall’s results were disturbing to some financial economists. They seemed to imply that the stock market is dominated by erratic market psychology, or “animal spirits”—that it follows no logical rules. In short, the results appeared to confirm the irrationality of the market. On further reflection, however, economists came to reverse their interpretation of Kendall’s study. ■ It soon became apparent that random price movements indicated a well- functioning or efficient market, not an irrational one. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 4. Evolution of The Efficient Market Hypothesis Why was Kendall’s attempt to find recurrent patterns in stock price movements fail? Do you have any idea? Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 5. Reasons for Kendall’s failure ■ For example, suppose that Kendall's model predicts with great confidence that XYZ stock price, currently at $100 per share, It will rise dramatically in 3 days to $110. What would all investors with access to the model’s prediction do today? Obviously, they would place a great wave of immediate buy orders to cash in on the prospective increase in stock price. The net effect would be an immediate jump in the stock price to $110. The forecast of a future price increase will lead instead to an immediate price increase. In other words, the stock price will immediately reflect the “good news” implicit in the model’s forecast. ■ This simple example illustrates why Kendall’s attempt to find recurrent patterns in stock price movements was likely to fail. A forecast about favorable future performance leads instead to favorable current performance, as market participants all try to get in on the action before the price jump. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 6. Random Walks ■ More generally, one might say that any information that could be used to predict stock performance should already be reflected in stock prices. As soon as there is any information indicating that a stock is underpriced and therefore offers a profit opportunity, investors flock to buy the stock and immediately bid up its price to a fair level, where only ordinary rates of return can be expected. These “ordinary rates” are simply rates of return commensurate with the risk of the stock. ■ However, if prices are bid immediately to fair levels, given all available information, it must be that they increase or decrease only in response to new information. New information, by definition, must be unpredictable; if it could be predicted, then the prediction would be part of today’s information. Thus stock prices that change in response to new (that is, previously unpredicted) information also must move unpredictably. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 7. Random Walks ■ This is the essence of the argument that stock prices should follow a random walk, that is, that price changes should be random and unpredictable. Far from a proof of market irrationality, randomly evolving stock prices would be the necessary consequence of intelligent investors competing to discover relevant information on which to buy or sell stocks before the rest of the market becomes aware of that information. ■ If stock price movements were predictable, that would be damning evidence of stock market inefficiency, because the ability to predict prices would indicate that all available information was not already reflected in stock prices. Therefore, Efficient Market Hypothesis (EMH) notion developed. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 8. Efficient Market Hypothesis (EMH) ■ EMH says stock prices already reflect all available information. A forecast about favorable future performance leads to favorable current performance, as market participants rush to trade on new information. ■ Result: Prices change until expected returns are exactly commensurate with risk. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 9. Cumulative Abnormal Returns Before Takeover Attempts: Target Companies Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 10. EMH and Competition Why should we expect stock prices to reflect “all available information”? Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 11. EMH and Competition ■ Strong competition assures prices reflect information. ■ Information-gathering is motivated by desire for higher investment returns. ■ The marginal return on research activity may be so small that only managers of the largest portfolios will find them worth pursuing. ■ Stock prices fully and accurately reflect publicly available information. ■ Once information becomes available, market participants analyze it. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 12. EMH and Competition So, Are all stock efficiently priced? ■ Emerging markets like Bangladesh Stock Market that are less intensively analyzed than U.S. markets or in which accounting disclosure requirements are less rigorous may be less efficient than U.S. markets. ■ Small stocks that receive relatively little coverage by analysts may be less efficiently priced than large ones. Still, while we would not go so far as to say that you absolutely cannot come up with new information, it makes sense to consider and respect your competition. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 13. Versions of The Efficient Market Hypothesis ■ Fama (1970) attempted to formalize the efficient market hypothesis theory and divided the overall efficient market hypothesis (EMH) depending on the information set involved. Those are: ■ Weak-form Efficient Market Hypothesis. ■ Semistrong-form Efficient Market Hypothesis. ■ Strong-form Efficient Market Hypothesis. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 14. Weak-form Hypothesis ■ The weak-form hypothesis asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest. This version of the hypothesis implies that trend analysis is fruitless. Past stock price data are publicly available and virtually costless to obtain. The weak-form hypothesis holds that if such data ever conveyed reliable signals about future performance, all investors already would have learned to exploit the signals. Ultimately, the signals lose their value as they become widely known because a buy signal, for instance, would result in an immediate price increase. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 15. Semistrong-form Hypothesis ■ The semistrong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Again, if investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 16. Strong-form Hypothesis ■ Finally, the strong-form version of the efficient market hypothesis states that stock prices reflect all information relevant to the firm, even including information available only to company insiders. This version of the hypothesis is quite extreme. Few would argue with the proposition that corporate officers have access to pertinent information long enough before public release to enable them to profit from trading on that information. Indeed, much of the activity of the Securities and Exchange Commission is directed toward preventing insiders from profiting by exploiting their privileged situation. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 17. Versions of The Efficient Market Hypothesis All versions of the EMH have in common: They all assert that prices should reflect available information. We do not expect traders to be superhuman or market prices to always be right. We will always wish for more information about a company’s prospects than will be available. Sometimes market prices will turn out in retrospect to have been outrageously high, at other times absurdly low. The EMH asserts only that at the given time, using current information, we cannot be sure if today’s prices will ultimately prove themselves to have been too high or too low. If markets are rational, however, we can expect them to be correct on average. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 18. Implications of the EMH ■ Technical Analysis. ■ Fundamental Analysis. ■ Active Vs Passive Portfolio Management. ■ Diversification. ■ Resource Allocation. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 19. Technical Analysis ■ Technical Analysis is using prices and volume information to predict future prices. ■ Success depends on a sluggish response of stock prices to fundamental supply-and-demand factors. ■ The efficient market hypothesis implies that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. ■ Relative strength ■ Resistance levels Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 20. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 21. Fundamental Analysis ■ Fundamental Analysis - using economic and accounting information to predict stock prices. ■ Try to find firms that are better than everyone else’s estimate. ■ Try to find poorly run firms that are not as bad as the market thinks. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 22. Active vs Passive Management ■ Active Management ✓ An expensive strategy ✓ Suitable only for very large portfolios ✓ Security analysis ✓ Timing ■ Passive Management ✓ No attempt to outsmart the market ✓ Buy and Hold ✓ Index Funds ✓ Very low costs Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 23. Market Efficiency & Portfolio Management Even if the market is efficient a role exists for portfolio management: ■ Diversification. ■ Appropriate risk level. ■ Tax considerations. ■ Other considerations. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 24. Resource Allocation ■ If markets were inefficient, resources would be systematically misallocated. ■ Firm with overvalued securities can raise capital too cheaply. ■ Firm with undervalued securities may have to pass up profitable opportunities because cost of capital is too high. ■ Efficient market ≠ perfect foresight market. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 25. Empirical Tests of Market Efficiency ■ Event studies. ■ Assessing performance of professional managers. ■ Testing some trading rule. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 26. Event Studies ■ Empirical financial research enables us to assess the impact of a particular event on a firm’s stock price. ■ The abnormal return due to the event is the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 27. How Tests Are Structured ■ Empirical financial research enables us to assess the impact of a particular event on a firm’s stock price. ■ The abnormal return due to the event is the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 28. How Tests Are Structured ■ Market Model approach: a. rt = a + brmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = rt - (a + brMt) c. Cumulate the excess returns over time. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 29. Issues in Examining the Results ■ Magnitude Issue ■ Selection Bias Issue ■ Lucky Event Issue ■ Possible Model Misspecification. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 30. Are Markets Efficient? ■ Magnitude Issue ✓ Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort. ■ Selection Bias Issue ✓ Only unsuccessful investment schemes are made public; good schemes remain private. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 31. Are Markets Efficient? ■ Lucky Event Issue ✓ Any bet on a stock is simply a coin toss. There is equal likelihood of winning or losing the bet. However, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets. For every big winner, there may be many big losers, but we never hear of these manager. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 32. What Does the Evidence Show? ■ Weak-Form Tests – Returns over the Short Horizon ✓ Momentum: Good or bad recent performance continues over short to intermediate time horizons. – Returns over Long Horizons ✓ Episodes of overshooting followed by correction. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 33. What Does the Evidence Show? ■ Predictors of Broad Market Returns – Fama and French ✓ Aggregate returns are higher with higher dividend ratios. – Campbell and Shiller ✓ Earnings yield can predict market returns. – Keim and Stambaugh ✓ Bond spreads can predict market returns. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 34. Semistrong Tests: Market Anomalies ― The Small Firm in January Effect. ― The Neglected Firm Effect and Liquidity Effects. ― Book-to-Market Ratios. ― Post-Earnings Announcement Price Drift. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 35. The Small Firm in January Effect The January effect is a hypothesis that there is a seasonal anomaly in the financial market where securities' prices increase in the month of January more than in any other month. This calendar effect would create an opportunity for investors to buy stocks for lower prices before January and sell them after their value increases. As with all calendar effects, if true, it would suggest that the market is not efficient, as market efficiency would suggest that this effect should disappear. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 36. The Neglected Firm Effect and Liquidity Effects A theory that explains the tendency for certain lesser-known companies to outperform better-known companies. The neglected firm effect suggests that the lesser-known companies are able to generate higher returns on their stock shares, because they are less likely to be analyzed and scrutinized by market analysts. The smaller firms might also exhibit better performance, because of the higher risk/higher reward potential of small, lesser-known stocks, with a higher relative growth percentage. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 37. Book-to-Market Ratios It has generally been observed that stocks of companies with high book- to-market ratios outperform stocks with low book-to-market ratios. Studies have shown that this effect seems to be independent of the stock's beta, and therefore, independent of systematic risk. This effect could be explained by the fact that companies with low book-to-market ratios tend to be companies that investors expect to grow rapidly. However, rapid growth continually declines as companies grow larger— hence, growth in stock prices will be diminished as the P/E ratio declines as future expectations of further growth are lowered. As the P/E ratio drops, the return also drops. Furthermore, stocks with high book-to- market ratios tend to decline less in bear markets, since there is less risk when the market value of a company is close to its book value. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 38. Post-Earnings Announcement Price Drift Earnings announcements can have variable effects on stock prices. Sometimes stock prices go up until the earnings are announced, then decline on the news—or they may decline before the announcement if expectations are not positive. Expectations usually are based on analysts' reports, and their forecast of future earnings. Many websites publish a consensus of earnings expectations. If the actual reported earnings differs significantly from what was expected, then this earnings surprise can have a large effect on the subsequent stock price for an extended time. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 39. Strong-Form Tests: Inside Information ― The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon. ― SEC requires all insiders to register their trading activity. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 40. Interpreting the Anomalies ▪ The most puzzling anomalies are price-earnings, small-firm, market-to- book, momentum, and long-term reversal. ― Fama and French argue that these effects can be explained by risk premiums. ― Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 41. Explanations of Anomalies ▪ May be risk premiums. ▪ Behavioral explanations. ― Forecasting errors. ― Overconfidence. ― Regret avoidance. ― Framing and mental accounting. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 42. Interpreting the Evidence ▪ Anomalies or data mining? ― Some anomalies have disappeared. ― Book-to-market, size, and momentum may be real anomalies. ▪ Anomalies over time ― Attempts to exploiting them move prices to eliminate abnormal profits. ― Chordia, Subramanyam, and Tong study found attenuating. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 43. Interpreting the Evidence ▪ Bubbles and market efficiency ― Prices appear to differ from intrinsic values. ― Rapid run up followed by crash. ― Bubbles are difficult to predict and exploit. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 44. Stock Market Analysts ▪ Some analysts may add value, but: ― Difficult to separate effects of new information from changes in investor demand. ― Findings may lead to investing strategies that are too expensive to exploit. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 45. Mutual Fund Performance ▪ The conventional performance benchmark today is a four-factor model, which employs: ― The three Fama-French factors (the return on the market index, and returns to portfolios based on size and book-to-market ratio) ― Plus a momentum factor (a portfolio constructed based on prior-year stock return). Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 46. Mutual Fund Performance ▪ Consistency ― Carhart – alphas positive before fees, negative after. ― Bollen and Busse – support for performance persistence over short time horizons. ― Berk and Green – skilled managers will attract new funds until the costs of managing those extra funds drive alphas down to zero. Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 47. So, Are Markets Efficient? ■ The performance of professional managers is broadly consistent with market efficiency. ■ Most managers do not do better than the passive strategy. ■ There are, however, some notable superstars: – Peter Lynch, Warren Buffett, John Templeton, George Soros Mahmudul Hassan, Finance (7th batch), Jagannath University.
- 48. Thanks for being with us. Mahmudul Hassan, Finance (7th batch), Jagannath University.