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Presentation on:

Efficient Market Theory

Presented By:
Hitesh Punjabi
Efficient Market Theory

Do security prices reflect information ?


An efficient capital market is one in which security prices adjust rapidly to the arrival of new
information and, therefore, the current prices of securities reflect all relevant information.

Whether markets are efficient has been extensively researched and remains controversial

Definition of Efficient Market Hypothesis EMH


Efficient market hypothesis(EMH) is an idea partly developed in the 1960s by Eugene Fama.
An investment theory that states it is impossible to "beat the market" because stock market
efficiency causes existing share prices to always incorporate and reflect all relevant information.
According to the EMH, stocks always trade at their fair value on stock exchanges, making it
impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As
such, it should be impossible to outperform the overall market through expert stock selection or
market timing, and that the only way an investor can possibly obtain higher returns is by
purchasing riskier investments.
EMH is highly controversial and often disputed. Believers argue it is pointless to search for
undervalued stocks or to try to predict trends in the market through either fundamental or
technical analysis
Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount
of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten
the market over long periods of time, which by definition is impossible according to the EMH.
Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow
Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can
seriously deviate from their fair values.
Classification of Efficient Market Hypothesis

The three classification of efficiency as set out by Fama are:


1) Weak form of efficiency; which absorbs only past price and volume data and those in
returns of the market.
2) Semi-Strong form of efficiency, which absorbs all publicly available information
3) Strong Form of efficiency which absorbs all publicly and privately held information

This Hypothesis postulates that the market is efficient under free market conditions and
it absorbs all the information through demand and supply forces. This absorption is of
different degrees.
Classification of Efficient Market Hypothesis

Weak Form
The weak form states that the current market prices of shares already reflect all the available
information that is contained in the historical sequence of prices.
This weak form of efficient market hypothesis holds that all historical and past information is
absorbed in the market forces
They hold that prices move in random fashion, Independent of the past and hence there is no
benefit in examining the past prices.
This implies that past rates of return and other market data should have no relationship with future
rates of return
This hypothesis contradicts the statements of Technical Analysts, who state historical price
movements can help the forecast the future price trends and the prices move in a predictable
manner.

Semi-Strong Form
The Semi-Strong form of the efficient market hypothesis postulates that current prices of stocks
not only reflect all the information contained in the historical prices but also reflects all publicly
available knowledge about the companies.
To Analyse public information on corporate reports, policy statements on dividends, rights, bonds
and other corporate information will not yield consistent superior returns to analyst. The reason is
that as soon as such information is publicly available, it is absorbed and reflected in stock prices.
Even if the market absorption is imperfect it will not be possible for the analyst to obtain superior
returns on consistent basis.
The absorption even if it is incomplete or incorrect, it will not continue for long and it will not place in
same fashion and in a consistent manner.
There can be over adjustments and under adjustments and in the absence of any consistency, the
results are not predictable and analyst cannot take advantage of the fundamentals and information
on them, to gain superior investment returns
Classification of Efficient Market Hypothesis

Strong Form
The strong form of efficient market hypothesis remains that not only is publicly available information
useless to the investor but all information is useless to gain superior investment returns.
This means that no information, be it public, private, or inside can be used to consistently earn
superior investment returns by the analyst, because market absorbs all the information by itself.
This assumes perfect markets in which all information is cost-free and available to everyone at the
same time
The market absorbs efficiently all information whether past, published and present or insider
information.
To Counter the above arguments it is stated that mutual funds with their better and inside information
gain more and earn superior returns. Besides Brokers and sub-brokers who are in the trading, can
have inside information and can gain excess profits and empherical tests have proved the same.

Random Walk Hypothesis


Several studies address the issue of whether stock price behavior is a random walk or not. Robert
(1959) and Osborne (1959) found that stock price movement follows a random walk.
The random walk hypothesis simply states that at a given point in time, the size(quantum) and
direction of the next price change is random with respect to the knowledge available at that point in
time.
According to theory securitys intrinsic values change and market prices move randomly around these
intrinsic values. The new information affecting the market arrives at random intervals. This new
information will force the analyst to re estimate the intrinsic value and again the stock prices move
randomly around the new intrinsic value.
this Theory thus states that security prices move randomly in a continuous fashion to set new
equilibriums. There may be upward or downward movements and changes take place in a random
manner.
Random Walk Assumptions
This theory is based on following Assumptions
1) Market is perfect and free without trade restrictions
2) Market absorbs all the information quickly and efficiently
3) Information is free and costless and is quickly available to all at the same time
4) Information is unbiased and correct
5) Market Players can analyse the information quickly and the information is absorbed in the
market through buy and sell signals
6) Demand and supply pressures are absorbed in the market through price changes. Such
absorption leads to quick and prompt movements in prices which are random in fashion.
Weak-form of market efficiency Test:
There have been three major methods to test the dependence of return on time (Weak-form of market
efficiency): serial correlation tests, filter rule test, Run tests etc.

Serial correlation tests


One way to test for randomness in stock prices changes is to look at their serial correlations (also
called auto- correlations). Is the price changes in one period correlated with the price change in some
other period?

if such auto correlation are negligible, the price changes are considered to be serially independent.

Numerous serial correlation studies, employing different stocks, different time-lags and different time-
periods, have been conducted to detect serial correlations.

Initial Studies have failed to discover any significant serial correlations. Subsequent studies
discovered minor positive correlations.

Filter Rule Test


An n percent filter rule may be defined as follows: if the price of a stock increases by at least n
percent, buy and Hold it until its price decreases by at least n percent from subsequent high. When the
price decreases by at least n percent or more, sell it

If the behavior of stock prices changes is random, filter rules should not outperform a simple buy-and-
hold strategy.

Many Studies have been conducted employing different stocks and different filter rules. By and large,
they suggest that filter rules do not outperform a simple buy-and hold strategy.
Weak-form of market efficiency Test:

Run Test
Given a series of stock price changes, each price change is designated a a Plus(+) if it
represents an increase or a minus (-) if it represents a decrease. The resulting series , for
example, may look as follows:
++-++--+
A run occurs when there is no difference between the sign of two changes. When the sign of
change differs, the run ends and new run begins.
For example in the above series of plus and minuses, there are five runs as follows
++------------1
- -----------2
++--------------3
-- ---------------4
+--------------5
To test series of price changes for independence, the number of runs in that series is
compared to see whether it is statically different from the number of runs in a purely random
series of the same size.
By and large the results of these studies seem to strongly support the random walk
model.
Semi- Strong Market efficiency Test

To test semi- strong market efficiency, empirical studies have been conducted hat have examined the
following questions
Is it possible to earn superior risk-adjusted returns by trading on information events like earnings
announcements, stock-splits, bonus issues or acquisition announcement? A scheme based upon trading on an
information event is usually tested with an event study.
Is it possible to earn superior returns by trading on an observable characteristic of a firm like P/E ratio, P/BV
ratio or dividend yield? A scheme based upon trading on observable characteristic is tested using portfolio
study.
Event Study
An event study examines the market reactions to and the excess market returns around a specific information
event like acquisition announcement or stock split. The key steps involved in an event study are as follows

1)Identify the event to be studied and pin point the date on which the event was announced
2)Collect returns data around the announcement date
3)Calculate the excess returns, by the period, around the announcement date for each firm in the sample.:-
the excess returns is calculated by making adjustments for market performance and risk. For example if the
capital asset pricing model is employed to control for risk the excess return is calculated as :
ERJT = RJT- BetaJ* RMT
Were ERJT is excess return on the firm j for period t, Beta J is the beta for firm j, R MT is the excess returns on the
market for period t
4) Compute the average and standard error of excess returns across all firms
The average excess returns is
J=M
ERt = ERJT
J=1 m
Semi- Strong Market efficiency Test

Were ERt is the average excess return for period t, ER jt is the excess returns for jth firm for
period t and m is the number of firms in the event study.
The standard error of the excess return is the standard deviation of the sample average
5) Assess whether the excess returns around the announcement date are different from zero,
estimate the T stastics for each day:
T Staistic for excess return on day t= Average excess return
Standard error
Statistically significant T statics imply that the event has a bearing on returns; the sign
of the excess returns indicates whether the effect is positive and negative.

Results of Event Studies


The results of event studies are mixed. Most event studies support the semi-strong form of
efficient market hypothesis.
Strong Market efficiency Test

To test the strong form efficient market hypothesis, researchers analysed the returns earned
by certain groups(like corporate insiders, specialists on stock exchanges and mutual fund
managers) who have access to information which is not publicly available.

Empirical evidence broadly suggests that following


Corporate insiders and stock exchange specialist( who have who have monoplistic access
to buy and sell order position) earn superior rates of return, after adjustment of risk.

Mutual fund managers do not, on an average, earn superior rate of return.


January Effect

Several theories have been put forth to explain why the January Effect occurs. One such explanation
holds that mutual fund managers will sometimes go shopping at the end of December to purchase
stocks that have appreciated significantly during the year -- a deceptive practice, known as "window
dressing." Any holdings that a fund owns at year-end will be listed in its annual report to shareholders,
and it always looks good for a portfolio to contain a few extra "winners." Demand from these
institutional investors can sometimes drive prices higher.

Furthermore, as the end of the year approaches, many investors unload shares of poorly performing
stocks. Some of them may be simply trying to cut their ties to bad investments in order to get a fresh
start to the new year. Primarily, though, year-end trading is heavily influenced by tax considerations,
and many people will sell their losers in order to realize capital losses that can be used to offset capital
gains elsewhere. Once the new year begins, the proceeds from those sales are often redeployed back
into the market, thereby sending stock prices higher.

Finally, the last explanation can be attributed to investor psychology. For many people, the beginning of
January is simply a popular time to invest. Saving more money may be a New Year's Resolution for
some, or a way to put year-end bonuses to work. Whatever the reason, stocks typically trend higher at
the beginning of January.
MONDAY EFFECT

A theory that states that returns on the stock market on Mondays will follow the prevailing trend from
the previous Friday. Therefore, if the market was up on Friday, it should continue through the weekend
and, come Monday, resume its rise.

A tendency of a stock market's returns to be relatively lower, or may even be negative, on Monday
rather than any other day in the week. This theory also states that the returns on Monday are driven
by the closing performance of the stock on the previous Friday. This effect generally causes an
unstable performance of the stock market during the first hour of the trading day.

Breaking down Monday Effect


Some studies have shown a similar correlation, but no one theory has been able to accurately explain
the existence of the Monday effect.
Small Firm Effect

A theory that holds that smaller firms, or those companies with a small market capitalization,
outperform larger companies
The theory holds that smaller companies have a greater amount of growth opportunities than larger
companies. Small cap companies also tend to have a more volatile business environment which can
lead to a large price appreciation.
Small cap stocks tend to have lower stock prices, and these lower prices mean that price
appreciations tend to be larger than those found among large cap stocks
Thank
You

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