Efficient Capital Market PDF

Efficient Capital Market  Key Concepts Efficient market hypothesis Forms of market efficiency Implications of EMH Empirical evidence Efficient market model Practicality of how is efficiency tested: -Weak form hypothesis -semi strong hypothesis...

Efficient Capital Market  Key Concepts Efficient market hypothesis Forms of market efficiency Implications of EMH Empirical evidence Efficient market model Practicality of how is efficiency tested: -Weak form hypothesis -semi strong hypothesis -strong hypothesis Keynes: “Markets can stay irrational longer than you can stay solvent”  Definitions of Market Efficiency Efficient market is one where the market price is an unbiased estimate of the true value of the investment. First extensive tests were undertaken that demonstrated that, contrary to popular believe, certain types and ways of using information (past prices) did not lead to superior profits. When evidence along these lines accumulated, academics developed a theory to explain these findings and the efficient market hypothesis was born (Al-Mudhaf, 1983, p. 56).”  Who Introduced EMH Fama (1970) first introduced the idea of the EMH. Building on the earlier work of Samuelson (1965) and earlier writers, he argued that, financial markets with free entry, no agent could make abnormal returns by exploiting publicly available information. The efficient market hypothesis holds that a market is efficient if it is impossible to make economic profits by trading on information already available to market participants. Main concern: How quickly do prices of shares adjust to reflect the new information?  Stock markets and the EMH The construct of “economic man” embedded in traditional finance /EMH incorporates at least (see (Rabin 2002, p 600) the following assumptions: Investors have well-defined stable preferences, [even if those preferences are never explained or challenged] Investors base their preferences between choices on expected outcomes resulting from their choice (not changes in expected outcomes), Investors maximise their own (or their families) well-being, or utility in economists’ language, Investors discount expected pay-offs by geometrically increasing amounts to obtain their  Forms of Market The various forms of Efficiency the efficient market hypothesis differ in terms of the information that security prices should reflect. – Weak form efficiency: the current price reflects the information contained in all past prices. – Semi-strong form efficiency: the current price reflects the information contained not only in past prices but all public information (including financial statements and news reports). – Strong form efficiency: the current price reflects all information, public as well as private. Cont’d…Forms of Market Efficiency Strong-form: Semistrong-form: Weak-form: Past prices & volume Public information Public and private information  EMH Update Fama (1991) has updated his definitions: "Efficient Markets: II," Fiftieth Anniversary Invited Paper, Journal of Finance 46 (Dec 1991), 1575-1617. – Weak form – Semi-strong  Now tests for return predictability – Strong form  Now tests for insider information  Information and Market Efficiency (i) Good News at t=0 Bad News at t=0 Pric Price e P A PB PB PA Time t= Time t=0 0 In an efficient market, prices should adjust quickly to new information!  Information and Market Efficiency(ii) Good News at t=0 Good News at t=0 Under reaction Overreaction Price Price PA PA PB PB t=0 Time t= Time 0 In an efficient market, prices should not under react or overreact to new information. 11  Why does it matter? If prices do fully reflect all current information, it would not be worth an investor’s time to use information to find undervalued securities. If prices do NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.  Cont’d…why does it matter? Investors are rational and have rational expectations: investors process all available information efficiently to form correct (rational) expectations Assumes prices respond immediately and correctly to all new information Thus price = value always or correctly reflects the fundamentals (risk) – Summarise as p = p* Prices + returns are not predictable Stresses risk-based explanations Chief advocates:  Prof Gene Fama Chicago  Prof Ken French Dartmouth  Cont’d…why does it matter? Where the market shows signs of inefficiency, economic theories of share pricing such as CAPM and APT may become weak in explaining, or predicting what is observed in the financial markets. The investment decisions of firms are based to a larger extent on signals they get from the capital market. As such if the capital market is efficient, the cost of obtaining capital will accurately reflects the prospect for each firm.  Cont’d…why does it matter? Companies frequently repurchase their shares because they feel they have been undervalued by the market. If the market is strong form efficient, this is untenable because the share is never undervalued by the market Investment projects are often postponed or financed through debt rather than with equity because managers feel that share prices have fallen below their intrinsic value based on available public information  Implications for Security Analysis Weak-form efficiency holds: – Trading rules based on an examination of past prices are worthless. Past performance is not an indicator of future performance. Semi-strong form efficiency holds: – Information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.  Cont’d…Implications for Security Analysis Strong-form efficiency holds: – The value of any security analysis is suspect. Professional investors should fare no better in picking securities than ordinary investors. Not even “insiders” would be able to “beat the market” on a consistent basis.  What market efficiency does not imply An efficient market does not imply that: stock prices cannot deviate from true value; in fact, there can be large deviations from true value. The deviations do have to be random. no investor will 'beat' the market in any time period. To the contrary, approximately half of all investors, prior to transactions costs, should beat the market in any period. no group of investors will beat the market in the long term. In case they do, this is because they are lucky and not because of their investment strategies.  Market efficiency Theory: Empirical The question on whether share prices respond Evidence rapidly and accurately to the receipt of new information is empirical. Studies in this area examine the nature of the markets’ reaction to events such as the announcement of earnings, dividends and share splits. They estimate excess returns with the vicinity of the event. The excess return in a given period is described as the difference between share’s actual return for the period and the expected return, given the share’s characteristics line and the performance  Efficient market model To make the theory of efficient market testable, the process of price formation is specified in detail and can be classified in three models of: 1.Expected Return or Fair Game Model 2.The Sub-Martingale Model 3.The Random Walk Model  Efficient Market: Expected Return or Expected return or the ‘fair game’ properties of the modelFair are Game Model the implications of two assumptions. – First, the conditions of market equilibrium can be stated in terms of expected returns and – second, the information if fully utilised by the market in forming equilibrium expected returns and current prices as well. The role of the ‘fair game’ models in the theory of efficient markets can be traced to Samuelson (1965) and Mandelbrot (1966).  Cont’d…Fair Game Model The efficient market hypothesis (EMH) implies that the return on a security is a ‘fair game’ with respect to a given information set. ~   E P j , t  1 t j , t........(1) Or E ~ r j , t  1 t  0 Where E is the expected value; Pjt is the price of security j at time t; Pjt +1is its price at t+1; rjt is the period percentage return (Pjt + 1 – Pjt)/ Pjt; t is a symbol for whatever information is assumed to be “fully reflected” in the price at t; and the tildes indicate that  Cont’d…Fair Game Model The fundamental principle of FG for the behaviour of prices was that speculations should be a fair game; in particular, the expected profit to the speculator should be zero. The fair game model implies that on an average the conditional abnormal return is zero.  The Sub-Martingale Model The sub martingale model held that the expected value of next period’s price projected on the basis of information is equal to or greater than current prices  Cont’d…The Sub- Martingale Model When the expected return and price changes are zero means that the price sequences follow a martingale. As for example, if we have a stochastic variable Xt, which has the property: E ( X t 1 |  t )  X t Then Xt is said to be a martingale where the best forecast of all future values of Xt+i (i 1) is the current value of Xt. When the agent knows Xt, no other information in t helps to improve the forecast.  Cont’d…The Sub- Martingale Model A sub martingale assumption implies trading rules based only on information sequence can not have greater profits than a policy of always buying and holding the security during the future period.  Random Walk Model When the successive price changes are independent and identically distributed (i.e., it shows no uniform pattern) means the price changes follow random walk.  Cont’d…Random Under the randomWalk Model walk model, the behaviour of prices under the EMH will wander randomly with or without drift (around an increasing trend). A stochastic variable is said to follow random walk with drift parameters , when X t 1   X t   t 1........(3) Where t+1 is an identically and independently distributed random variable with: t+1 = 0. A random walk without drift = 0. Clearly, Xt+1 is a martingale and change in Xt+1 = Xt+1 – Xt is a fair game (for = 0).  Cont’d…Random The random walkWalk Model model states that the sequence (or the order) of the past returns is of no consequence in assessing the distributions of future returns (Fama, 1970). The movement of stock prices from day to day DO NOT reflect any pattern. Statistically speaking, the movement of stock prices is random (skewed positive over the long term).  How is Efficiency Tested? No abnormal return (other than by chance) x j ,t 1 r j ,t 1  E (r j ,t 1  t ) E ( x j ,t 1 ) 0 Additionally, x j ,t 1 should be uncorrelated with t So….. Can an investor earn systematic excess returns using a particular information set?  How is efficiency tested? (ii) Normal returns are equilibrium returns (compensation for systematic risk), implied by an asset pricing model. Joint tests of market efficiency and the asset pricing model. Past information contains nothing about the magnitude of the deviation of today’s return from expected return. Abnormal returns (or forecast errors) depend on news at t+1.  How is efficiency tested?: Statistical testsWeak Form of independence between rates of returns. Hypothesis Comparison of risk-return results for trading rules that make investment decisions based on past market information relative to simple buy and hold strategy.  Weak Form Hypothesis (ii) Autocorrelation tests of independence measure the significance of positive or negative autocorrelation over time. Does the rate of return on day t correlate with the return on day t-1, t-2 or t-3. Empirical results show insignificant correlation for short time horizons. Results that consider portfolios of stocks of different market size have indicated that autocorrelation is stronger for portfolios of small market size.  Weak Form Hypothesis (iii) Another test of statistical independence is the run test. Given a series of price changes, each change is designated as a plus (+) or minus (-). A run occurs when two consecutive changes are the same. You compare the number of runs for a given series to the expected value of the number of runs that should occur in a random series. Empirical Studies have confirmed the independence of stock price changes over time.  Weak Form Hypothesis (iv) Tests of trading rules. Advocates of efficient market hypothesize that investors cannot derive abnormal returns using trading rules that depend solely on past information. Filter rules- an investor trades when the price change exceeds a filter rule. An investor using a % filter would envision a positive break through if the stock were to rise % from some base, suggesting that the price will continue to decline. You compare the number of runs for a given series to the expected value of the number of runs that should occur in a random series. Empirical Studies have shown that after transaction costs filter rules do not out perform a buy and hold strategy.  Cont’d… Security price and time. Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth Edition © John Wiley & Sons, Inc.  How is efficiency tested?: Semi-strong Form Studies to predict future rates of return using available information beyond pure market information (e.g.,Hypothesis past prices, volume). These studies can involve either:  Time series analysis of returns  Cross section distribution of returns for individual stocks Event studies that examine how fast stock prices adjust to specific significant economic events. Advocated of efficient market hypothesis that investors cannot derive abnormal returns using  Cont’d…Semi-strong January Effect Studies of returns reveal that returns in January are significantly higher than returns in any other month of the year. Possible explanations: The effect may be related to tax- motivated selling and buying. Fund managers might rush to buy back all those money-losing stocks they had previously  Cont’d…Semi Strong Day-of-the-Week Effect Mondays are historically bad days for the stock market  Cont’d….Semi-Strong Predicting future returns. Many studies have found a positive relationship between the aggregate dividend yield D/P and future returns. Several studies have also considered variables related to the term structure of interest rates. a) default spread, the difference between lower grade and Aaa-rated long term corporated bonds. b) the term structure spread, the difference between long term treasury bond yield and the yield on one month treasury bills. When the dividend yield and default spread are high investors are requiring a high return. This occurs during poor economic environment. Investors require a return above normal to shift consumption from the present to the future. Cont’d….Semi-Strong  Cont’d…Semi-Strong Predicting Cross Sectional Returns Assuming efficiency all securities should have equal risk adjusted returns. Studies in this category attempt to determine if you can use public information to predict what stocks will enjoy above average or below average risk adjusted returns. Several studies have examined the relationship between Price/Earnings ratios for stocks and the returns on the stocks. Some suggest that low P/E stocks will outperform high P/E stocks. The market overestimates/underestimates.  Cont’d…Semi-Strong Predicting Cross Sectional Returns (ii) Investing in firms with low market capitalization will provide superior risk-adjusted returns.  Cont’d…Semi-Strong Predicting Cross Sectional Returns (iii) Possible Explanation: Information uncertainty - Small cap stocks are not researched as thoroughly as larger stocks. Lack of information amounts to relatively higher risk and potentially greater opportunity to exploit market mispricing. Illiquidity - Small cap stocks are relatively illiquid. Hence, their excess returns can perhaps be explained simply as compensation for this  Cont’d…Semi-Strong Book value/Market value ratio: Studies have found positive relationship between current values of this ratio and future returns. Fama French (1992) found that both BV/MV and size effect dominate other ratios. These ratios proxy some risk factors.  Cont’d…semi-strong Form Hypothesis Event Studies Event studies examine abnormal returns around significant economic information. Under EMH hypothesis returns adjust quickly to announcements. How fast do security prices react to the release of surprise information? Are returns after the announcement abnormally high, low or normal?  Cont’d…semi-strong Form Hypothesis 1. Collect a sample of firms that had a surprise announcement; 2. Determine the precise day of the announcement and call this day zero; 3. Define the period to be studied; if we analysed 60 days around the event, we would designate –30,-29, …,0,+1,+2,…,+30 etc; 4. For each firm in the sample, compute the return on each of the days studied; 5. For each firm in the sample, compute the “abnormal” return on each of the days studied; 6. For each day compute the average abnormal return;  Cont’d…semi-strong Form Hypothesis Excess return around announcement day. Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth Edition © John Wiley & Sons, Inc.  Cont’d…semi-strong Form Hypothesis Corporate Events: Take Over  Cont’d…semi-strong Form Hypothesis Earning Announcements Source: MacKinlay (1997)  Cont’d…semi-strong Form Hypothesis Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth Edition © John Wiley & Sons, Inc.  How is efficiency tested?: Strong No group of investors have Form access to private Hypothesis information that will allow them to experience above average profits. Corporate insiders Stock exchange specialists Security analysts at Value line Professional money managers.  Cont’d…Strong Form source: Malkiel (1996).  Adaptive Market Hypothesis (AMH):Lo, Biological, Not Physical, View of Markets: A (2004) 1. Individuals Act In Self-Interest 2. Individuals Make Mistakes 3. Individuals Learn and Adapt 4. Competition Drives Adaptation and Innovation 5. Natural Selection Shapes Market Ecology 6. Evolution Determines Market Dynamics  Cont’d…AMH Simon’s Notion of “Satisficing”: ƒ Heuristics, Not Optimization ƒ Develop Mental Models To Simplify Decisions ƒ Learning Is A Key Evolutionary Adaptation ƒ Cost: Leads To Certain Biases And Regularities ƒ How Do We Know Where To Stop Optimizing? Answer ⇒ Evolutionary Forces  Cont’d…AMH Where Do Heuristics Come From? ƒ Consider the Problem of Getting Dressed ƒ Wardrobe: 5 Jackets, 10 Pants, 20 Ties, 10 Shirts, 10 Pairs of Socks, 4 Pairs of Shoes, 5 Belts ƒ 2,000,000 Possible Outfits! ƒ Suppose It Takes 1 Second To Evaluate Each Outfit ƒ How Long Will It Take To Get Dressed? ƒ 23.1 Days! How Do We Get Dressed So Quickly?  Cont’d…AMH Practical Implications: ƒ Risk/Reward Relation Not Stable (Nonlinear) ƒ Risk Premia Are Time-Varying ƒ Limited Arbitrage Exists From Time To Time ƒ Strategies Wax And Wane ƒ Adaptation and Innovation Are Keys To Survival Survival Is All That Matters!  Cont’d…AMH Unifying Behavioral and Rational Finance: ƒ An Evolutionary Perspective ƒ Sociobiology (Wilson) ƒ Ecology of Markets (Niederhoffer and Zeckhauser) ƒ Neuroeconomics Are You The Fittest?  Summary 1. What is market efficiency? 2. What are the models used to test for efficiency? 3. How is efficiency tested for? 4. Weak Form 5. Semi-Strong 6. Strong 7. What is adaptive market hypothesis?