Are Financial Markets Effcient

Roadmap
The Efficient Market Hypothesis
Stronger Version of Efficient Market Hypothesis
Evidence on the Efficient Market Hypothesis
Evidence Against Market Efficiency
Behavioural Finance

The Efficient Market Hypothesis
The prices of securities in financial markets fully reflect all available information

Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return.
Example 6.1

Rationale behind the hypothesis
Arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit opportunities, i.e., returns on a security that are larger than what is justified by the characteristics of that security.
Pure arbitrage – no risk
In an efficient market, all unexploited profit opportunities will be eliminated
Not everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds

Stronger Version of the Efficient Market Hypothesis
Not only do scientists define an efficient market as one in which expectations are optimal forecasts using all available information, but they also add the condition that an efficient market is one in which prices reflect the true fundamental value of securities.
In an eff. Market prices are always correct and reflect market fundamentals

Implications of the above
In an eff. market one investment is as good as any other because the securities prices are always correct
A security’s price reflect all available information about the intrinsic value of the security
Security prices can be used by managers of both financial and non-financial firms to assess their cost of capital accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making or not

Evidence on the Efficient Market Hypothesis
Evidence in favour of Market Efficiency
Performance of investment analysts and mutual funds
One implication is that you cannot beat the market
“Investment Dartboard”
Mutual funds did not beat the market
Conclusion: having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future.

Evidence on the Efficient Market Hypothesis
Do stock prices reflect publically available information?
Favourable stock announcements do not, on average, cause stock price to rise
Random-walk behaviour of stock prices
Future changes on stock prices should, for all practical purposes, be unpredictable
Technical analysis-popular technique to predict stock prices

Evidence Against Market Efficiency
Small firm effect
Due to rebalancing of portfolios by institutional investors, low liquidity of small-firm stocks, large information costs in valuing small firm, etc
January Effect
Inconsistent with random walk beahaviour
Market overreaction
Pricing errors are corrected slowly to news announcements
Investor can earn abnormally high returns

Evidence Against Market Efficiency
Excessive volatility
Fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value.
Robert Shiller, fluctuations in S&P 500 could not be justified by the subsequent fluctuations in dividends of the stocks making up index.
Mean reversion
Stocks with low return today tend to have high returns in the future, vice versa
Not a random walk

Evidence Against Market Efficiency
New information is not always immediately incorporated into stock prices
On average stock prices continue to rise for some time after the announcement of unexpectedly high profits and they continue to fall after surprisingly low profit announcement

Overview of the Evidence on the EMH
How valuable are publishable reports by Investment Advisors?
We cannot expect to earn abnormally high return, a greater than the equilibrium return
Human investment advisors in San Francisco do not on average even outperform an orangutan!
A person who has done well regularly in the past cannot guarantee that he or she will do well in the future

Overview of the Evidence on the EMH
Should you be skeptical of hot tips?
If this is new information and you get it first…
Do stock prices always rise when there is a good news?
A puzzling phenomenon: when good news is announced, the price of the stock frequently does not rise.
Stock prices will respond to announcements only when the information being announced is new and unexpected
Prices reflect publically available information
Sometimes a stock price declines when good news is announced. Why?

Overview of the Evidence on the EMH
Efficient market prescription for an investor
Hot tips, investment advisors, technical analysis cannot help the investor to outperform market (because judgment is based on publically available information)
“buy and hold” strategy – fewer brokerage commission paid
Invest in no-load mutual fund