EFFICIENT CAPITAL

MARKET
 EFFICIENT CAPITAL MARKET

An efficient capital market is one which security

prices adjust rapidly to the arrival of new information,
and, therefore, the current prices of securities reflect
all information about the security.
 WHY SHOULD CAPITAL
MARKETS BE EFFICIENT?
SET OF ASSUMPTIONS IMPLY AN EFFICIENT CAPITAL MARKET:
1. A large number of profit-maximizing participants analyze and
value securities.
2. New information regarding securities comes to the market in a
random fashion.
3. The buy and sell decisions of all those profit-maximizing investors
cause security prices to adjust rapidly to reflect of new
information.
 ALTERNATIVE EFFICIENT
MARKET HYPOTHESIS
Efficient market hypothesis of investment gives the idea that the market cannot be beaten as
it incorporates all important determinative information into current share prices. Stock trade at
the fairest. To gain higher returns, investments is made through purely speculative that pose
substantial risk.
DIVIDED INTOR THREE SUBHYPOTHESIS:
1. Weak-form EMH
2. Semistrong-form EMH
3. Strong-form EMH
 WEAK-FORM EFFICIENT
MARKET HYPOTHESIS

Assumes that current stock prices fully reflect all security

market information, including the historical sequence of
prices, rates of return, trading volume data, and other
market-generated information.
 SEMI-STRONG-FORM
EFFICIENT MARKET
HYPOTHESIS

Asserts that security prices adjust rapidly to the release of

all public information; that is, current security prices fully
reflect all public information.
 STRONG-FORM EFFICIENT
MARKET HYPOTHESIS

Contends that stock prices fully reflect all information

from public and private sources. This means that no group of
investors has monopolistic access to information relevant to
the information of prices.
TESTS AND RESULTS OF
EFFICIENT MARKET
HYPOTHESIS
 WEAK-FROM TESTS
STATISTICAL TEST OF INDEPENDENCE
-the tests used to examine the weak form of the EHM test for
the independence assumption Examples of these tests are the
autocorrelation tests (returns are not significantly correlated
over time) and runs tests (stock price chances are independent
over time).
TRADING TEST
-the rules that traders follow are invalid. An example of a
trading test would be the filter rule, which shows that after
 SEMI-STRONG-FORM TEST
EVENT TESTS
-An event test analyzes the security both before and after
an event, such as earnings. The idea behind the event test is
that an investor will not be able to bring in an above average
return by trading on an event.
REGRESSION/TIME SERIES TESTS
-Remember that a time series forecasts returns based
historical data. As a result, an investor should not be able to
achieve an abnormal return using this method.
 STRONG-FROM TESTS

Given that the Strong-form implies that the market is

reflective of all information, both public and private, the
tests for the strong-form center around groups of investors
with excess information. These investors are as follows:
INSIDERS
-Insiders to a company, such as senior managers, have access
to inside information. SEC Regulations forbid insiders for using
this information to achieve abnormal returns.
EXCHANGE SPECIALIST
-An exchange specialist recalls runs on the orders for a
specific equity. It has been found however, that exchange
specialists can achieve above average returns with this specific
order information.
ANALYSTS
-The equity analyst has been an interesting test. It analyzes
whether an analyst’s opinion can help an investor achieve
above average returns. Analysts do typically cause movements
in the equities they focus on.
INSTITUTIONAL MONEY MANAGERS
-Institutional money managers, working for mutual funds,
pensions and other types of institutional accounts, have been
found to have typically not perform above the overall market
benchmark on a consistent basis.
 BEHAVIORAL FINANCE
Considers how various psychological traits affect how
individuals of groups act as investors, analysts, and portfolio
managers.
It is a relatively new field that seeks to combine behavioral
and cognitive psychological theory with conventional
economics and finance to provide explanations for why people
make irrational financial decision.
 EXPLAINING BASIS
Two related bases that seriously impact analysis and investment decisions.
1. Belief Perseverance
-means that once people have formed and opinion they cling to it too tightly and for too
long.
2. Anchoring
-individuals who are asked to estimate something, start with an initial arbitrary (casual)
value and then adjust away from it.
Implications of Efficient
Capital Markets

Capital markets are efficient as related to numerous sets

of information that rapidly adjust the stock prices
There are substantial instances where the market fails to
rapidly adjust to public information
Efficient Markets and
Technical Analysis

Assumptions of technical analysis directly oppose the notion of

efficient markets
Technicians believe that new information is not immediately
available to everyone, but disseminated from the informed professional
first to the aggressive investing public and then to the masses
Technicians also believe that investors do not analyze information
and act immediately - it takes time
 Therefore, stock prices move to a new equilibrium after the
release of new information in a gradual manner, causing trends in
stock price movements that continue for periods
Technical analysts develop systems to detect movement to a new
equilibrium (breakout) and trade based on that
Which contradicts rapid price adjustments indicated by the EMH
If the capital market is weak-form efficient, a trading system that
depends on past trading data can have no value
Efficient Markets And
Fundamental Analysis
Fundamental analysts believe that there is
a basic intrinsic value for the aggregate stock market, various
industries, or individual securities and these values depend
on underlying economic factors
Investors should determine the intrinsic value of an
investment at a point in time and compare it to the market
price
By doing a superior job of estimating intrinsic value, superior market
timing decisions can be made and generated above-average returns.
This involves:
1. Aggregate market analysis
2. Industry analysis
3. Company analysis
4. Portfolio management
Aggregate Market Analysis
with Efficient Capital
Markets
EMH implies that examining only past economic events is not
likely to lead to out performing a buy-and-hold policy because
the market adjusts rapidly to known economic events
Merely using historical data to estimate future values is
not sufficient
So we must estimate the relevant variables that cause long-
run movements
Industry and Company
Analysis with Efficient
Capital Markets

Wide distribution of returns from different industries and

companies justifies industry and company analysis
We must understand the variables that effect rates of
return and do a superior job of estimating future values of
these relevant valuation variables, not just look at past data
Efficient Markets and
Portfolio Management
Portfolio Managers with Superior Analysts:
Concentrate efforts in mid-cap stocks that do not receive
the attention given by institutional portfolio managers to the
top-tier stocks
The market for these neglected stocks may be less
efficient than the market for large well-known stocks
Portfolio Managers without Superior Analysts:
Must proceed as follows:
1. Measure the risk preferences
2. Risky asset portfolio must be completely diversified on a global
basis
3. Minimize transaction costs
•Determine and quantify client’s risk preferences
•Construct the appropriate portfolio
•Diversify completely on a global basis to eliminate all
unsystematic risk
•Maintain the desired risk level by rebalancing the portfolio
whenever necessary
•Minimize total transaction costs