Market Prices and Market Efficiency PDF

AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency Session 02 Market Prices and Market Efficiency Contents 2.1 Determining the Stock Price 2.2 Security Prices and Random Walk 2.3 Market Efficiency Theory Review Questions Learning Outcomes Intro...

AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency Session 02 Market Prices and Market Efficiency Contents 2.1 Determining the Stock Price 2.2 Security Prices and Random Walk 2.3 Market Efficiency Theory Review Questions Learning Outcomes Introduction This session contains three major sub topics. First, we discuss how the Stock Price are determined. The second topic explains the random price movement of stocks on the stock market. And the third topic explains why the capital markets are expected to be efficient and the factors that lead to an efficient market. Further we elaborate the three sub efficient market hypotheses and the implications of each of them. In conclusion we discuss about some empirical evidences that supports the efficient market hypotheses and growing number of other evidences that do not supports the efficient market hypotheses. 2020© The Open University of Sri Lanka 21 AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency 2.1 Determining the Stock Price In theory, a stock's Initial Public Offering (IPO) is done at a price equal to the value of its expected future dividend payments; the stock's price varies based on the demand and supply forces of the stock market. Much like any other market, stock market is driven by supply and demand. When a stock is sold, a buyer and seller exchange money for the ownership of the stock. The price for which the stock is purchased becomes the new market price in the market. When a next stock is sold, this price becomes the newest market price, etc. The stock market determines prices by constantly-shifting movements in the supply and demand for stocks. The higher the demand for a stock, the higher the price of the stock and vice versa. The more the supply of stocks, the lower it drives the price and vice versa. Many market forces contribute to supply and demand, and thus to a company's stock price. Price Quantity Figure 2.1: Demand-to-buy Schedule 22 2020© The Open University of Sri Lanka AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency Price Quantity Figure 2.2: Supply-to-sell Schedule Price Quantity Figure 2.3: Aggregate demand-to-buy and supply-to-sell According to the above figure the market price of this particular stock is Rs. 25/= 2.2 Security Prices and Random Walk In 1953 Maurice Kendall suggested that the price movement of stocks on the stock market was random. Kendall had expected to find regular price cycles, but to his surprise they did not seem to exist. Instead, he found that the prices of stocks and commodities seemed to follow a random walk. Random walk theory suggests that changes in stock prices have the same distribution and are independent of each other. 2020© The Open University of Sri Lanka 23 AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency In short, random walk theory proclaims that stocks take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run. Therefore, it is safe to assume the past movement or trend of a stock price or market cannot be used to predict its future movements. Hence, random walk theory believes it's impossible to outperform the market without assuming additional risk. We can use following binomial tree to explain the Random Walk model 106.09 H 103 H T 100 100.43 T H 97.5 T 95.06 Figure 2.4: Binomial tree of random walk model schedule Suppose that you are given Rs.100 to play a game. At the end of each week a coin is tossed. If it is Head, you win 3% and tails, you lose 2.5%. After two weeks the possible outcomes are as in the figure above. We can calculate the correlation between each observation and the observations at previous time in order to show random walk. A plot of these correlations is called an autocorrelation plot. Given the way that the random walk is constructed, we would not expect a strong autocorrelation with the previous observation and a linear fall off from there with previous lag values. 24 2020© The Open University of Sri Lanka AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency 2.3 Market Efficiency Theory Imagine a world in which; 1. all investors have costless access to currently available information about the future 2. all investors are capable analysts 3. all investors pay close attention to market prices and adjust their holdings appropriately In such a market a security’s price will be a good estimate of its investment value. Investment value is often referred to as the securities “fair” or “intrinsic” value. If every security’s price is equal to its investment value at all times, then such a market is said to be an efficient market. The efficiency in case of financial market means that the price which investor is paying for financial asset fully reflects fair or true information about the intrinsic value of this specific asset or fairly describes the value of issuer of this security. The key term in the concept of the market efficiency is the information available for investors trading in the market. It is about the fact whether the market price of a stock reflects all the information available. An informational efficient market is defined as a financial market where asset prices rapidly reflect all available public information. This means that all available information is already impounded in an asset’s price, so investors should only expect to earn a return necessary to compensate them for their opportunity cost, anticipated inflation, and risk, which prevent the abnormal returns. As and when the investors attempt to capitalize on new information, which is not already accounted for in prices, the stock prices should adjust immediately. However, it is commonly agreed that investors over-or under-react to information. This does not necessarily mean that markets are inefficient unless the reaction is biased (consistently over- or under-reacting). In this case investor, who recognizes the bias, will be able to earn abnormally high risk adjusted returns. 2020© The Open University of Sri Lanka 25  AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency This phenomenon is illustrated in Figure 2.5. If the market is efficient, when the new information hits the market price instantly adjusts to its new equilibrium level, but if the market is inefficient, the market may underreact or overreact to new information. If there is under reaction, the price adjustment is gradual. If there is overreaction, the market price overshoots the new equilibrium value. If market is inefficient, between the time of the news revelation and the adjustment to the new equilibrium value, informed investors would be able to make profit at the expense of less sophisticated investors. Price Overreaction New Price Efficient Under reaction Old Price New Information Time Figure 2.5. Market reaction to new information According to Fama (1970) “a market in which prices always fully reflect available information is called efficient.” He believed that all information available at a particular time is taken into consideration when estimating the price of financial assets in an efficient market. Even though this definition delivers us with an initial idea of what an efficient market is, it does not certainly describe what is meant by available information. And that problem is addressed by Fama (1970), making a distinction between three types of efficient markets, depending on what information is comprised in the information set which are known as Efficient Capital Market Hypothesis (ECMH). 26 2020© The Open University of Sri Lanka AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency The three levels of market efficiency are; ▪ Weak form efficient market (information set = historical price information); ▪ Semi-strong form efficient market (information set = all publicly available information); ▪ Strong form efficient market (information set = all information, both public and private). Fama’s Formulation of the EM Model  E ( p j ,t +1 I t ) = 1 + E (rj ,t +1 I t ) p j ,t  Where; E = Expected Pj =Market Price of Jth Security It =In formation available at time t rj = Return of Jth Security When the markets are efficient, then investors cannot earn abnormal return (other than by chance) trading on the available information set. Accordingly, Fama’s notation, the level of over– or undervaluation of a security is defined as: x j ,t +1 = p j ,t +1 − E ( p j ,t +1 I t ) E (x j ,t +1 I t ) = 0 2020© The Open University of Sri Lanka 27 AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency Where; E = Expected Pj =Market Price of Jth Security It =In formation available at time t x j ,t +1 ==level p j ,tof − E (or +1 over– ,t +1 I t ) p jundervaluation at time t+1 That implies that there will be no expected under-or overvaluation of securities based on the available information set. That information is always impounded in security prices Weak form efficiency Weak form of market efficiency suggests, that current asset prices reflect all past prices and price movements, i.e., all trade-related information. In other words, all worthwhile information about previous prices of the stock has been used to determine the today’s price. Thus, the investor cannot use the same information to predict tomorrow’s price and still earn abnormal profits. What this actually means is that so-called technical analysis of stocks is obsolete and does not generate any risk-adjusted excess returns over the return of the general market. Empirical evidence from most of the stock markets around the world suggests that the capital markets are weak- form efficient. In other words, it is not possible to outperform the market by using information on past stock prices. The fact that the price changes in the future cannot be predicted has been called the random walk hypothesis. This theory implies that the future price movements are random because they are caused by unexpected news. In short, this is the idea that stock prices become random and unpredictable. This constant distribution assumption is only a one part of weak form of efficiency as the weak form of efficiency can hold, even though the distribution of prices shifts over time. 28 2020© The Open University of Sri Lanka AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency Semi-strong form efficiency Semi-strong form of market efficiency suggests that current stock prices reflect all publicly available information. The difference between public information and market related information is that public information also includes announcements of company events, economic and political news and events. Thus, if investors employ investment strategies based on the use of publicly available information, they cannot earn abnormal profits. Suppose that in today’s newspaper, a certain company announces news that affects its stock market price. Under the assumption of semi-strong efficient markets, this information is not useful to make any abnormal profits, as the market would already fully reflect this publicly available information. It does not mean that prices change instantaneously to reflect new information, but rather that information is accounted for rapidly in determining stock prices. What this also means is that fundamental analysis of stocks is rendered ineffective. Empirical evidence supports the idea that the largest stock markets in the world are for the most part semi-strong efficient. Typically, when people refer to Efficient Markets, they really mean Semi-strong form efficiency, because the use of insider information is strictly prohibited in almost every market around the world. This, in turn, implies that careful analysis of companies that issue stocks cannot consistently produce abnormal returns. Strong form efficiency Strong form of market efficiency assumes that asset prices reflect all public and private information. In other words, the market (which includes all investors) knows everything about all securities, including information that has not been released to the public. The strong form implies that you cannot make abnormal returns even from trading on inside information, where inside information is information, which is not yet public. Corporate insiders (directors, large shareholders) are a group of market participants, who are involved in management and have access to non- 2020© The Open University of Sri Lanka 29 AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency public information. Profit from insider information through short-term trading gains is illegal in most countries. However, they are allowed to buy and sell securities of the company they are employed in, for long-term investment purposes. Such transactions are called insider trading and have to be disclosed to securities exchange commission and to the public. Stock market analysis has shown that when insiders are trading company shares, frequently their results are good. Therefore, insider reports to securities exchange commission have become an important source of investor’s information. In merger and acquisition transactions the price of the acquired firms stock tends to rise significantly before public announcement of the transaction. The assumption is made, that some insiders may be profiting from non-public information. However, the strong form of market efficiency is not supported by the empirical studies. In fact, event studies state that the opposite is true; gains are available from inside information. Thus, various stock markets, as the empirical evidence suggests, are essentially semi-strong, but not strong form efficient 2.3.1 Implications of Market Efficiency In summary, many empirical studies have been conducted to test for the three forms of market efficiency. Most of these studies suggest that the stock market is indeed highly efficient in the weak form, reasonably efficient in the semi-strong form (at least for the larger and more widely followed stocks), but not true for the strong form because abnormally large profits are often earned by those with inside information. If the Efficient Market Hypothesis are correct, it would be a waste of time for most of us to seek bargains by analysing stocks. Because, if stock prices already reflect all publicly available information and hence are fairly priced, we can “beat the market” only by luck or with inside information, making it difficult, if not impossible, for majority of the investors to consistently outperform the market averages. In support of this viewpoint, efficient 30 2020© The Open University of Sri Lanka AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency market advisors often point out that even the professionals who manage mutual fund portfolios do not, on average, outperform the overall stock market returns consistently. It is important to understand that market efficiency does not imply that all stocks are always priced correctly. It is apparent that at any point in time there would be some stocks overvalued and others undervalued. However, as the efficient markets hypothesis implies, to beat the market, you must have above-average information, above-average analytical skills, or above- average luck. Review Questions 1. “Sock price refers to the current price that a stock is trading for on the market. The price of a stock will go up and down in relation to a number of different factors.” Explain how stock prices are determined using suitable graphs. “The terms investing and financing can be used interchangeably”. Do you agree with the statement? Discuss with appropriate examples. 2. All the Stock Markets are Efficient. Do you agree? 3. What does it mean by the price you pay for a stock is fair? 4. Describe the 3 forms of efficient market hypothesis. 5. Discuss the criticisms of Efficient Market Hypothesis (EMH) 6. If the weak-form market efficiency hypothesis is valid, what do the security prices reflect? 7. Given the following 03 cases, determine in each case whether the Efficient Market Hypothesis violated or not with the reason. Through the introduction of an advanced computer software into the analysis of past stock price movements, a brokerage firm is able to predict price movements well enough to earn a consistent 3% profit, adjusted for risk, above normal market returns. On average, investors in the stock market this year are expected to earn a positive return on their investment. Some investors will earn considerably more than others. You have discovered that the square root of any given stock price multiplied by the day of the month provides an indication of the direction in price movement of that particular stock with a probability of 65% 2020© The Open University of Sri Lanka 31 AFU6422: Unit 1 Session 02: Market Prices and Market Efficiency Learning Outcomes Upon the completion of this session the students will be able to: 1. Explain why capital markets should be efficient 2. Identify the factors contribute to an efficient market 3. Explain efficient market hypothesis and their implications 4. Identify anomaly related to the efficient market hypothesis 32 2020© The Open University of Sri Lanka