market eficiency ..........abt weak form semi strong and storng form of market is given................

1. Market Efficiency – Part I

2. Market Efficiency & Modern Financial
Management
 Efficiency in financial versus product markets
 Why financial markets tend to be more competitive & efficient
 Introduction to market efficiency
 Key feature of modern economic thought & market workings
 What is an efficient market?
 The three forms of market efficiency
 The three “forms” of market efficiency
 Weak form, semi-strong form, and strong-form efficiency
 What does market efficiency imply for corporate financial
management?
 How do markets process firm-specific information releases?
 How should managers communicate with investors & analysts?

3. Financial Versus Product Markets
 Many examples of corporations creating value through
real asset investments
 R&D, product innovations, marketing programs create value
 Few product markets approach perfect competition standard
 Manufactured goods face barriers to entry (branding, capital
requirements, physical distribution costs)
 Far fewer opportunities to create value through purely
financial activities
 Financial markets much larger, more competitive, more
transparent, more homogeneous than product markets
 Innovations cannot be patented; easily imitated
 Arbitrage is easy & safe; keeps relative prices in line
 Much harder to create value thru purely financial activities

4. Economic Definitions Of Efficiency
Form Definition Example
Allocative A financial system exhibits Stock market investors shun
allocative efficiency if it security offers from firms in
allocates capital to its declining industries, but welcome
highest and best (most offerings from firms in more
productive) use. promising industries.
Operational A financial system exhibits Average daily trading volume on
operational efficiency if it the New York Stock Exchange
produces a given output at now over 10 times its level of 20
lowest possible input cost-- years ago--in the same Wall
or, alternatively, it Street location. The NASDAQ
maximizes output for any market’s trading volume has
given level of inputs. increased even more.
Informational In a market exhibiting When company A receives a
informational efficiency, takeover bid from company B
asset prices incorporate all that seems certain to succeed,
relevant information fully the stock price of A increases
and instantaneously. immediately to reflect the per
share bid premium.

5. Efficient Market Hypothesis
(EMH)
• 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.
• Why look at market efficiency?
– Implications for business and corporate
finance
– Implications for investment

6. Early Study on Market Behavior
– In the 1950s, researchers couldn’t find any
predictable pattern in stock prices.
– Immediate conclusion was that these results
appeared to support the irrationality of the
market.

7. Does randomness = irrationality?
– Suppose researchers found that security prices
are predictable and then developed a model to
predict the prices.
– Following this model, investors would reap
unending profits simply by purchasing stocks
that would appreciate in price and selling stocks
that would decrease in price!

8. Ramifications of Predictability
– Suppose a model predicts that XYZ stock
price (currently $100) would rise dramatically
in three days to $110.
– Obviously, everybody will want to BUY it; no
one would want to SELL it.
– The prediction of under-pricing of a security
would lead to an immediate price increase!

9. Ramifications of Predictability
– As soon as there is any information predicting
that stock XYZ is under-priced, investors will
flock to buy the stock and immediately bid up its
price to a fair level.
– However, if prices are bid immediately to fair
levels, given all available information, it must be
that these prices increase or decrease only in
response to new information.
– New information (by definition) must be
unpredictable, which means that stock prices
should follow a “random walk.”

10. Grossman-Stiglitz Theorem
ASSUMPTIONS:
Two types of investors:
- Uninformed: Liquidity or noise traders
- Informed: Spend serious amounts
of money to dig up
information no one else
has

11. Grossman/Stiglitz Theorem
• Informed: Do research until marginal
benefit = marginal cost.
• Uninformed: Do NO research.
• Some of the informed have marginal
benefits > marginal costs, some have
marginal benefits < marginal costs. On
average, marginal benefit = marginal

12. Grossman/Stiglitz Theorem
Example:
A manager of a $50 billion fund wants to increase
returns 1/2% above what the market averages.
How much is she willing to spend to do this??
Willing to spend:
$50 billion x .005 = $ 0.25 billion
or
$250 million on research to find incorrectly priced
stocks.

13. Grossman/Stiglitz Theorem
• So, the informed make the market efficient for
the uninformed! Justification for professionals!!
• If active managers fail to use information properly
or have excessive transaction costs, they will do
worse than a passive portfolio.
• In equilibrium, investors should earn the same
return investing in a passive index fund as in an
actively managed fund after research &
transaction costs.

14. The Hard
Truth
• NO EASY MONEY!

15. Random Walk Hypothesis
If stock prices follow a random walk (with or
without a trend), then future stock prices
cannot be predicted based on past stock
prices.
New information is a “surprise”.
When new information arrives, stock prices
will adjust immediately.

16. Example: Positive Surprise
Price
Stock Price of XYZ
New Information Arrives
Time

17. Efficient Market Hypothesis
(EMH)
• In 1970 Eugene Fama defined the efficient
market hypothesis and divided it into 3 levels.
– Weak Form Efficient
– Semi-Strong Form Efficient
– Strong Form Efficient
• Each differs with respect to the information
that is reflected in the stock prices.

18. Relation of 3 Forms of EMH
Strong
Weak
Past Market All Public All Public &
Info Info Private Info
Semi-
Strong

19. Three Forms Of Market Efficiency
Form Definition Example
Weak Financial asset (stock) prices Nothing of value is to be
Form incorporate all historical gained by analyzing past stock
information into current prices; price changes, since this
future stock prices cannot be doesn’t help you predict future
predicted based on an analysis price changes. Renders
of past stock prices. “technical analysis” useless.
Semi- Stock prices incorporate all The relevant information in an
strong publicly available information SEC filing will be incorporated
Form (historical and current); there will into a stock price as soon as
not be a delayed response to the filing is made public.
information disclosures.
Strong Stock prices incorporate all Stock prices will react to a
Form information--private as well as dividend increase as soon as
public; prices will react as soon the firm’s board of directors
as new information is generated, votes--and before the board
rather than as soon as it is announces its decision
publicly disclosed. publicly.

20. EMH: Weak Form
• Stock Prices reflect all past market price
and volume information
– It is impossible to make abnormal risk
adjusted returns by using past prices or
volume data to predict future stock prices.

21. Technical Analysts
• Do not think the stock market is weak
form efficient.
• Believe that investors are emotionally
driven and predictable. Therefore, you
can exploit this predictability, as it
shows up in past prices and volume.
• “Quants” – use computers to find
patterns.

22. Technical Analysts
Price
Buy Here Stock Price of XYZ
Stock First Starts Rising
Time

23. EMH: Semi-Strong Form
Stock Prices reflect all publicly available
information about a firm.
It is impossible to make abnormal risk-
adjusted returns by analyzing any
public information to predict future
stock prices.

24. Fundamental Analysts
• Do not think the stock market is semi-
strong form efficient.
• They use publicly available information
to identify firms that are worth more (or
worth less) than everyone else’s
estimate of their values.

25. EMH: Strong Form
Stock Prices reflect all information (public
and private) about a firm.
It is impossible to make abnormal risk-
adjusted returns by analyzing publicly
available information or trading based
on private or “inside” information.

26. Trading On Inside Information
• Not legal to trade on inside information
• offenders prosecuted
• Rules protect the small investor

27. Question…
• What is the meaning of the Efficient
Markets Hypothesis to the Investment
Industry?
– debate between active and passive portfolio
management.
– Billions of dollars are at stake!

28. Active or Passive Management
• Active Management
– Security analysis
– Timing
• Passive Management
– Buy and Hold
– Index Funds

29. Market Efficiency & Portfolio
Management
• Even if the market is efficient a role exists
for portfolio management:
– Appropriate risk level
– Tax considerations
– Other considerations

30. Ironic Situation
• If the stock market is efficient, you may
be better off buying index funds.
• However, if everyone buys index funds,
market would not be as efficient,
because no one is willing to search for
information.

31. Difficult to Determine If Market
is Efficient
If we can find people who beat the market based
on skill, this would imply abnormal returns are
possible and the market is not efficient.
Difficult to distinguish luck from skill!

32. Applied to Professional Investors
• Record whether or not an investor beats the
market each year for 10 years.
• By pure chance there is a 50% probability an
investor will beat the market in any given year
(ignoring fees and expenses).
• If there are 10,000 professional money
managers, how many will have a perfect record
of beating the market every year due to chance?

33. SOLUTION
Possible Permutations (outcomes) over 10
years
= 210 = 1024
Probability of being correct each year for
10 years
= 1 / 1024 = 0.00097
Expected number of “gurus”
= 10,000 x 0.00097 = 9.7