Efficient Market Hypothesis - Presentation Transcript

1. Efficient Market Hypothesis

2. How can we forecast price of share? • Fundamental Analysis • Technical Analysis
• Market price of the share is not only dependent on demand and supply but
several other factors – can be termed as INFORMATION. • The perceptual
inferences of all information available in the market, if quantified accurately
should help in predicting the expected price of the securities. • This has been
advocated thro’ informal market efficiency theory. L M LEARNING S Made
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3. History • Developed by Professor Eugene Famaat the University of Chicago
Booth School of Business. • The efficient-market hypothesis was first expressed
by Louis Bachelier, a French mathematician, in his 1900 dissertation, "The
Theory of Speculation". • The efficient-market hypothesis emerged as a
prominent theory in the mid-1960s. Paul Samuelson had begun to circulate
Bachelier's work among economists. L M LEARNING S Made Simple
4. Why Efficient Market Hypothesis? • To test the form of market – extent of
efficiency. • To make sure that one can accurately forecast the market, discover
the market trend and help investors to make critical decisions. L M LEARNING S
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5. The most important consequences of this hypothesis is that it is not possible to
outperform the market (adjusted for risk) over the long term L M LEARNING S
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6. What is Efficient Market? • A market where there are large numbers of rational
profit maximizers actively competing, with each trying to predict future market
values of individual securities, and where important current information is almost
freely available to all participants L M LEARNING S Made Simple
7. Market Reaction to an unanticipated favorable event L M LEARNING S Made
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8. Market Reaction to anticipated favorable event L M LEARNING S Made Simple
9. Monday Effect.. L M LEARNING S Made Simple
10. Efficient Market Hypothesis • Securities prices always fully reflect all available,
relevant information about the security. • Note the key words of the definition:
“always,” “fully,” and “information.” • Two important questions – What is all
available information? – What does it mean to “Reflect all available
information?” L M LEARNING S Made Simple
11. All available information • Past Price : Weak Form • All public information :
Semi Strong Form – Past price, news etc.. • All information including inside
information : Strong Form L M LEARNING S Made Simple
12. Why should price reflect available information? • If not, there would be arbitrage
opportunities L M LEARNING S Made Simple
13. Early thinking about securities market prices (early 20th century): • Observers
noticed that the charts that tracked the pattern of stock market prices looked
similar to a chart of a random event, such as tossing a coin and marking an
increase if you get a “heads,” or a decrease if you get a “tails.” • They wondered
 why the stock market behaved like a random walk. L M LEARNING S Made
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14. Important! • The actual stock price was not seen to be random, only the CHANGE
in the price appeared to be random in occurrence. • In particular, using valuation
theory, it should be true that a common stock sells for a price that is the present
value of all the future cash flows (dividends) expected by investors. L M
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15. What would cause a stock price to change? • A reasonable answer is that the price
would change if investors obtain new information about the stock that causes
them to revise their forecast about the stock’s future return. • New information
that causes investors to be more optimistic would cause them to revalue the stock
price higher. Negative information would result in lower price revaluations. L M
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16. Since new information arrives in the market in an unpredictable (random) fashion,
prices will change randomly as well. • Conclusion: New information is the cause
of securities price changes. Since one cannot predict whether the next piece of
new information will be favorable or unfavorable for a stock, the future changes
in stock prices are similarly unpredictable. L M LEARNING S Made Simple
17. Much empirical research has been done to examine how much (or how fully)
information is incorporated in market prices. • Questions about the extent of the
information incorporated has led to several terms to describe the degree of
efficiency exhibited in a particular market. • The three terms are “weak form
efficient,” “semi-strong form efficient,” and “strong form efficient.” L M
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18. The weak form efficient markets hypothesis - a definition, and some evidence: •
The weak form hypothesis maintains that past stock price changes cannot be used
to earn above average profits. (Because this information is available to all, and
thus, already incorporated in market price.) L M LEARNING S Made Simple
19. Weak form evidence: • Studies show that systems that try to predict the future
course of stock prices based upon some rule derived from the history (past days,
weeks, or months) of past stock price changes do not make profit greater than a
simple buy and hold strategy. • Statistical analysis of successive stock price
changes reveals that the correlation between price changes is approximately zero.
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20. Weak Form L M LEARNING S Made Simple
21. If a market is weak form efficient, then technical analysis should not be effective
in picking stocks for above average profits. L M LEARNING S Made Simple
22. Despite the evidence for market efficiency, there are many professional investors
who claim that technical analysis can be effective. Such claims are largely
unproven, but it shows that not everyone accepts the efficient market hypothesis.
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23. The semi-strong form efficient markets hypothesis - a definition and some
evidence: • The semi-strong form efficient markets hypothesis maintains that all
publicly available information is incorporated in stock prices. L M LEARNING S
Made Simple
24. Semi-strong form evidence: • Studies show that public announcements of
earnings, dividends, stock splits, etc. cause stock prices to immediately change to
reflect the new information. • Studies show that mutual funds (whose professional
managers would be expected to have access to the very best information
available) do not consistently outperform the average market indexes. L M
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26. If a market is semi-strong efficient, then picking stocks based on publicly
available information, should not yield profits greater than what could be obtained
using a simple buy and hold strategy. L M LEARNING S Made Simple
27. Evidence of efficient markets has given great impetus to the formation of “Index
Funds,” for investors wanting to minimize research costs and trading costs while
investing in a mutual fund that closely tracks a given market index. L M
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28. The strong form of the efficient markets hypothesis - a definition and some
evidence: • The strong form of the hypothesis maintains that all information
obtainable from any source whatever, is incorporated in market prices. L M
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29. Strong form evidence: • Studies show that “inside information” available to
corporate insiders or market specialists could be used to earn above average
trading profits • Yet, remember that using inside information is illegal!. Thus,
strong form inefficient markets may not be legally exploited to earn greater than
average profits, either. L M LEARNING S Made Simple
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32. In conclusion: • There is evidence that markets are weak form and semi- strong
form efficient, but probably not strong form efficient. • Yet it must be noted that
the tests of efficiency have largely focused on well developed markets in the
United States. Foreign markets have been studied less extensively, and may
exhibit less efficiency. This is especially true of markets in less developed
countries (sometimes called “emerging” markets). L M LEARNING S Made
Simple
33. Finally, it should be noted that there is some evidence that contradicts the
hypothesis. • Some market studies give evidence that a strategy as simple as
buying low P/E ratio stocks can result in above average profit. L M LEARNING
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34. The efficient market hypothesis has not been “proven,” however, it is a highly
regarded tenant in modern finance. • If markets are efficient, investors can expect
that prices are “fair,” and that the rate of return earned from a diversified portfolio
of securities over time will be approximately average for that class of securities. L
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