EFFICIENT MARKET HYPOTHESIS

One goal of government policy is to encourage the establishment of allocationally efficient markets in which the firms with the most promising investment opportunities have access to the needed funds. However, in order for markets to be allocationally efficient, they need to both internally and externally efficient.

Concept of Efficient Market

1. 2. 3. Fundamental Analysis Technical Analysis Efficient Market : The unexpected shocks in the stock markets can be explained by behavioral finance. - here information regarding the prices react immediately and correctly to new information, furthermore, changes in share prices will be completely random unless new information is received.

Relationship among Three Different Information Sets

All information relevant to a stock Information set of publicly available information Information set of past prices

EFFICIENT MARKET HYPOTHESE

Even if the market is efficient, there exists a role for portfolio managers
Find an optimal portfolio on the efficient frontier
Two-fund separation theorem

1 2

Maintain appropriate risk level Tax considerations

EFFICIENT MARKET HYPOTHESE

Do security prices reflect relevant information fully and immediately?
What kind of information? Past prices, trading volume, etc Weak form EMH Public information announced Semi-strong EMH Private information of managers Strong EMH Competition assures prices to reflect information Once information becomes available, market participants analyze it and trade on it

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price

Overreaction to good news with reversion Delayed response to good news

Efficient market response to good news -30 -20 -10 0 +10

+20

+30

Days before (-) and after (+) announcement

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price Efficient market response to bad news Delayed response to bad news

-30 -20 -10 Overreaction to bad news with reversion

+10

+20

+30

Days before (-) and after (+) announcement

Empirical Tests of Market Efficiency

Weak form efficiency Test profitability of some trading rules to see whether past price or volume contains useful information Semi-strong form efficiency Perform event studies around important announcements to see whether public information is reflected immediately Strong form efficiency Assess performance of professional managers or insiders to see whether they have superior information unknown to public investors

Test of Weak form

1 Auto Correlation test: First selected no. of select stock, the changes in the prices of these stocks are observed, then in another period same stocks the changes in the stock prices are noted. Correlation analysis is conducted. If the correlation between these changes is near or equal to zero, it implies that the price changes are independent of each other. r square. r2 = a Ey + b E xy n.Y2 / E Y2 n Y2 B = EXY n X Y / EX2 n X2 Filter Test: Filter are fixed at some percentage change and price movements are observed. Some mechanical trading strategies run on these filter levels on the premises that once a movement in prices has exceeded a fixed level of price movement called resistance and support levels, the security price will move in the same direction.

Test of Weak form

3 Run Test: A run is defined as a sequence of identical occurrence preceded and followed by different occurrences or by none at all, For testing the randomness of share price change is denoted by a plus + or a minus sign indicates that the price under consideration has increased compared to its preceding price. S.d. 2.n1.n2(2n1n2 n1 n2) (n1+ n2)2 (n1 + n2 1) Total number of runs = r Number of positive price changes = n1 Number of negative price changes = n2

Test of Semi Strong Form

1 Calculate abnormal returns around event windows (residual Analysis)
Using the market model, estimate the following: a. Rt = at + btRmt + et Expected Return = at + btRmt Excess Return = Actual Expected return = (at + btRmt + et) (at + btRmt) = et b. Cumulate the excess returns over event windows

Test of Semi Strong Form

2 Event Studies: Event studies aimed at testing the EMH by examining how abnormal rates of returns react to significant economic information. Proponents of EMH opine that returns would adjust very quickly to announcements of new information. This implies that it is not possible for investors to experience positive abnormal rates of return by responding positively to the announcement. Some of the events that bring out changes in the stock returns are stock splits, exchange listings, initial public offerings, unexpected world or economic events, and the announcement of significant accounting changes.

Test of Strong Form

Inside Information: = Trading by exchange officials = Trading by mutual fund managers Insider trading refers to dealing in securities by persons who are privy to specific information of companies. This possession of confidential information gives those persons undue advantage to either buy or sell the securities as the circumstance warrant. This specific information is not disclosed to the investors in the general course of business. 1. The regulation would now cover subscription in the primary issue based on inside information.

Test of Strong Form

2, Any person who holds more than 5% shares or voting rights in nay listed company shall disclose to the company, the number of shares or voting rights held by such person, within four working days of the receipt of allotment of shares or the acquisition of shares. Speculative reports in print or electronic media would not be considered as published information. Corporate dealing in securities of another company based on inside information is specifically prohibited. SEBI regulations also prohibit the insider to communicate or counsel other persons directly or indirectly about the confidential price sensitive information.

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EFFICIENT MARKET HYPOTHESE

Implications for investment

Will it be possible to beat the market consistently over time? Empirical evidence is mixed

In efficient markets, technical trading rules should not work since all of the past information is contained in current prices Evidence of overreaction or under reaction to information, etc.

Do stock prices follow random walk?

Stronger assumption than the EMH Expected price is increasing over time Positive trend and random about the trend

Implications for corporate finance and business

Should be difficult to find a project with positive NPVs

An internally efficient market is one in which brokers and dealer compete fairly, making the cost of transacting low and the speed of transacting high.