FINANCIAL MANAGEMENT II
CHAPTER 4: EFFICIENT CAPITAL MARKETS
4.1 Introduction
4.2 Three forms of EMH
4.3 Test of the three forms of market efficiency.
4.1 Introduction:
Early applications of computers in economics in the 1950s:
• Analyse economic time series.
• Study evolution of economic variables over time.
• Predict boom & bust periods.
Maurice Kendall: Presented a controversial paper to the Royal Statistical Society on
the behaviour of stock and commodity prices.
The stock price will immediately reflect the “good news” implicit in the model ́s
forecast.
- Overvalued —> Sell —> Price falls —> Equilibrium.
- Undervalued —> Buy —> Price rises —> Equilibrium.
Any information that could be used to predict stock performance should already be re-
flected in stock prices.
Prices increase or decrease only in response to new information.
“New information”= unpredictable
Stock prices that change in response to new (unpredictable) information also must move
unpredictably.
Random Walk Theory: The movement of stock prices from day to day DO NOT reflect
any pattern. Statiscally speaking, the movement of stock prices is random.
Efficient Capital Markets
• A market is efficient if prices "fully reflect" available information and adjust rapidly
to new information.
• In an efficient market, public information cannot be used to earn above market returns
after adjusting for risk.
• Efficient market DO NOT imply that investors cannot earn a positive return in the
stock market.
• They do mean that, on average, you will earn a return that is appropriate for the risk
undertaken
• There is not a bias in prices that can be exploited to earn excess returns.
What is the Efficient Market Hypothesis (EMH)?
• Securities are normally in equilibrium and are "fairly prices".
• Investors cannot "beat the market" expect through good luck or better information.
4.2 Three forms of EMH:
1. Weak form:
• Postulates that current prices fully reflect all information in PAST prices.
• Technical Analysis: using patterns in market data to predict price changes.
• If the stock market is weak form efficient, can technical analysis benefit investors? NO
2. Semi - Strong Form:
• Postulates that current prices fully reflect all past prices and ALL PUBLICLY avail-
able information.
• Fundamental analysis: using economic and accounting information to evaluate a secu-
rity.
• If the stock market is semi-strong form efficient, can fundamental analysis benefit in-
vestors? NO.
3. Strong Form:
• Postulates that current prices fully reflect all information, public and private.
• If the stock market is strong form efficient, do insiders have an advantage over other
investors? NO.
i.e., knowing a merger is going to take place before it is announced publicly will not
produce profits.
• Although illegal, evidence that prices move before public announcements, suggesting
insider information.
• Insider trading appears profitable, indicating markets are NOT strong form efficient.
- Fundamental Analyst:
- Research the value of stocks by delving into detailed accounting and operating
numbers.
- These analysts DO NOT believe in semi-strong form of market efficiency.
- Technical Analyst:
- Forecast stock prices based on the watching the fluctuations in historical prices.
- These analysts DO NOT believe any form of market efficiency.
4.3 Test of the three forms of market efficiency:
Weak form of EMH:
Researchers measured the profitability of some of the trading rules used by those in-
vestors who claim to find patterns in security prices.
Semi-strong form of EMH:
Researchers measured how rapidly security prices respond to different items of news,
such as earnings or dividend announcements, news of a takeover, or macroeconomic in-
formation.
Strong form of EMH:
Researchers have examined the recommendations of professional security analysts and
have looked for mutual funds or pension funds that could predictably outperform the
market.
