BUSINESS FINANCE/

FINANCIAL MARKETS & INSTITUTIONS

[B Sc (Hons) in Management]

SEMINAR 8

S8
Market Efficiency

1. Essence of EMH
• Refers to Information Processing Efficiency

• If market is efficient, new information is reflected in stock

prices without delay,

• security prices should always fully reflect the available

information

• you cannot “beat the market” (earn abnormal returns)

consistently

• If the information sips through slowly, then some

investors are profiteering at the expense of the rest of the
market
Market Efficiency

1. Assumptions
• Investors are rational

• Even if investors are not rational, their trades are still

random, ie, they will cancel each other without affecting
prices

• If their trades are not random, they will be met by

arbitrageurs, which will eliminate the influence of
irrational investors
Market Efficiency

1. A) WEAK FORM efficiency

(market instantly adjusts to all & any PAST
information)
• Share prices follow a random walk
• As a result, price changes are independent of another,
making it difficult to predict a future price based on a
series of past prices
Conclusion :
• Can’t make abnormal returns by looking at past trends
• A recent decline is no reason to think stocks will go up (or
down) in the future
• Evidence supports weak-form EMH, but “technical
analysis”/charting is still used
Market Efficiency

• A) WEAK FORM efficiency

Tests :
i. Serial Correlation
• Statistically measuring the correlation between the
price changes in one period vs the price changes in a
preceding period
• If the correlation coefficient is close to 0, then there is
likely to be no relationship, ie, market is weak form
efficient
ii. Mechanical Investment Strategies
• Assessing the effectiveness of trading strategies (ie,
active buying and selling) that use past data (eg.
moving average)
Market Efficiency
1. B) SEMI-STRONG FORM efficiency
(market instantly adjusts to all PUBLICLY
AVAILABLE information)
• Information refers to all and any public, including past
information
Conclusion :
• Can’t profit by looking at public information
• If all publicly available (and past) information is reflected
in stock prices, it doesn’t pay to examine at length annual
reports looking for undervalued stocks
• The market price is thus the best indicator of the risk-
return relationship of a share
• Evidence supports semi-strong form EMH, but
“fundamental analysis” is still being used
Market Efficiency

• B) SEMI-STRONG FORM efficiency

Tests :

i. Observing the price reaction of a stock (both speed and

direction) following an announcement which should have
an impact on the share price

ii. Comparing the performance of funds, after adjusting for

their risk differences. If a fund is able to generate better
return vs a randomly generated portfolio, then the
difference would be attributed to the manager’s skills and
access to information
Market Efficiency
1. C) STRONG FORM efficiency
(market instantly adjusts to ALL information)
• Information refers to all and past information, both
privately and publicly held

Conclusion :

• Impossible for investor to consistently outperform the

market, even with “inside” information

• Evidence DOES NOT support strong form EMH

Market Efficiency

1. Forms of Efficiency
Efficiency (as in price discovery) is measured by :
Output/Input = Stock Price/Information

Output Price Price Price

Information

Form of
Efficiency
Market Efficiency

Markets are generally efficient because :

• 100,000 or so trained analysts--MBAs, CFAs, and

PhDs--work for firms like Fidelity, Merrill, Morgan,
and Prudential

• These analysts have similar access to data and

large amount of funds to invest

• Thus, news is reflected in P0 almost

instantaneously
Market Efficiency

1. Challenges to Efficient Market Hypotheses

a) Investors are not always rational
• Unrealistic assumptions of “rationality”
• Sentiments & behaviour
b) Limited arbitrage
• Transaction cost
• Cost of information/analysis
• Not having perfect or good substitutes
c) Social Consequences
• Framing
• Motivations
• Norms
• Task performance effects
• Process of cultural transformation