Chapter 9

The Capital Markets and

Market Efficiency

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The notion that science, left to itself, is bound to
evolve more and more of the truth about the world
is another illusion, for science can never exist
outside a society, and that society, whether
deliberately or unconsciously, directs its course.

- Northrop Frye

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 Outline
Introduction
Role of the capital markets
Efficient market hypothesis
Anomalies

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 Introduction
Capital market theory springs from the
notion that:
People like return

People do not like risk

Dispersion around expected return is a

reasonable measure of risk
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 Role of the Capital Markets
Definition
Economic function
Continuous pricing function
Fair price function

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 Definition
Capitalmarkets trade securities with lives
of more than one year

Examples of capital markets

New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
Chicago Board of Trade
Chicago Board Options Exchange (CBOE)
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 Economic Function
The economic function of capital markets
facilitates the transfer of money from savers
to borrowers
E.g., mortgages, Treasury bonds, corporate
stocks and bonds

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 Continuous Pricing Function
Thecontinuous pricing function of capital
markets means prices are available moment
by moment
Continuous prices are an advantage to investors

Investors are less confident in their ability to

get a quick quotation for securities that do not
trade often
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 Fair Price Function
Thefair price function of capital markets
means that an investor can trust the
financial system
The function removes the fear of buying or
selling at an unreasonable price

The more participants and the more formal the

marketplace, the greater the likelihood that the
buyer is getting a fair price
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 Efficient Market Hypothesis
Definition
Types of efficiency
Weak form
Semi-strong form
Strong form
Semi-efficient market hypothesis
Security prices and random walks
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 Definition
The efficient market hypothesis (EMH) is
the theory supporting the notion that market
prices are in fact fair
The EMH is perhaps the most important
paradigm in finance

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 Types of Efficiency
Operational efficiency measures how well
things function in terms of speed of
execution and accuracy
It is a function of the number of order that are
lost or filled incorrectly

It is a function of the elapsed time between the

receipt of an order and its execution
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 Types of Efficiency (contd)
Informational efficiency is a measure of
how quickly and accurately the market
reacts to new information
It relates directly to the EMH

The market is informationally very efficient

Security prices adjust rapidly and accurately to new
information
The market is still not completely efficient
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 Weak Form
Definition
Charting
Runs test

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 Definition
Theweak form of the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past
The current price is a fair one that considers
any information contained in the past price data

Charting techniques or of no use in predicting

stock prices
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 Definition (contd)
Example

Which stock is a better buy?

Stock A

Current Stock Price

Stock B

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 Definition (contd)
Example (contd)

Solution: According to the weak form of the EMH, neither

stock is a better buy, since the current price already
reflects all past information.

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 Charting
Peoplewho study charts are technical
analysts or chartists
Chartists look for patterns in a sequence of
stock prices

Many chartists have a behavioral element

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 Runs Test
A runs test is a nonparametric statistical
technique to test the likelihood that a series
of price movements occurred by chance
A run is an uninterrupted sequence of the same
observation
A runs test calculates the number of ways an
observed number of runs could occur given the
relative number of different observations and
the probability of this number
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 Conducting A Runs Test
Rx
Z

where R number of runs
2n1n2
x 1
n1 n2
2n1n2 (2n1n2 n1 n2 )

n1 n2 (n1 n2 1)
2

n1 , n2 number of observations in each category

Z standard normal variable
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 Semi-Strong Form
The semi-strong form of the EMH states
that security prices fully reflect all publicly
available information
E.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.

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 Semi-Strong Form (contd)
Academic research supports the semi-strong
form of the EMH by investigating various
corporate announcements, such as:
Stock splits
Cash dividends
Stock dividends
Thismeans investor are seldom going to
beat the market by analyzing public news
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 Strong Form
The strong form of the EMH states that
security prices fully reflect all public and
private information
This means even corporate insiders cannot
make abnormal profits by using inside
information
Inside information is information not available
to the general public
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 Semi-Efficient
Market Hypothesis
Thesemi-efficient market hypothesis
(SEMH) states that the market prices some
stocks more efficiently than others
Less well-known companies are less efficiently
priced
The market may be tiered
A security pecking order may exist

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 Security Prices and
Random Walks
Theunexpected portion of news follows a
random walk
News arrives randomly and security prices
adjust to the arrival of the news
We cannot forecast specifics of the news very
accurately

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 Anomalies
Definition
Low PE effect
Low-priced stocks
Small firm effect
Neglected firm effect
Market overreaction
January effect
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 Anomalies (contd)
Day-of-the-week effect
Turn-of-the calendar effect
Persistence of technical analysis
Chaos theory

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 Definition
A financial anomaly refers to unexplained
results that deviate from those expected
under finance theory
Especially those related to the efficient market
hypothesis

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 Low PE Effect
Stocks with low PE ratios provide higher
returns than stocks with higher PEs

Supported by several academic studies

Conflicts directly with the CAPM, since

study returns were risk-adjusted (Basu)
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 Low-Priced Stocks
Stocks with a low stock price earn higher
returns than stocks with a high stock price

There is an optimum trading range

Everystock with a high stock price

should split
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 Small Firm Effect
Investing in firms with low market
capitalization will provide superior risk-
adjusted returns

Supported by academic studies

Implies that portfolio managers should give

small firms particular attention
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 Neglected Firm Effect
Security analysts do not pay as much
attention to firms that are unlikely portfolio
candidates

Implies that neglected firms may offer

superior risk-adjusted returns

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 Market Overreaction
The tendency for the market to overreact to
extreme news
Investors may be able to predict systematic
price reversals

Results because people often rely too

heavily on recent data at the expense of the
more extensive set of prior data
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 January Effect
Stock returns are inexplicably high in
January

Small firms do better than large firms early

in the year

Especially pronounced for the first five

trading days in January
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 January Effect (contd)
Possible explanations:
Tax-loss trading late in December (Branch)

The risk of small stocks is higher early in the

year (Rogalski and Tinic)

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 Types of Firms in January
January January return minus January return
return average monthly return after adjusting for
in rest of year systematic risk
S&P 500
Companies
Highly Researched 2.48% 1.63% -1.44%
Moderately 4.95% 4.19% 1.69%
Researched
Neglected 7.62% 6.87% 5.03%

Non-S&P 500
Companies
Neglected 11.32% 10.72% 7.71%
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 Day-of-the-Week Effect
Mondays are historically bad days for the
stock market

Wednesday and Fridays are consistently

good

Tuesdays and Thursdays are a mixed bag

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 Day-of-the-Week
Effect (contd)
Should not occur in an efficient market
Once a profitable trading opportunity is
identified, it should disappear

Theday-of-the-week effect continues to

persist

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 Turn-of-the-Calendar Effect
The bulk of returns comes from the last
trading day of the month and the first few
days of the following month

For
the rest of the month, the ups and
downs approximately cancel out

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 Persistence of
Technical Analysis
Technical analysis refers to any technique
in which past security prices or other
publicly available information are employed
to predict future prices
Studies show the markets are efficient in the
weak form
Literature based on technical techniques
continues to appear but should be useless
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 Chaos Theory
Chaos theory refers to instances in which
apparently random behavior is systematic or
even deterministic
Econophysics refers to the application of
physics principles in the analysis of stock
market behavior
E.g., an investment strategy based on studies of
turbulence in wind tunnels
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