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Chapter 6

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Chapter 6

Uploaded by

nitikasehgal2203
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© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 6

Are Financial
Markets
Efficient?
Efficient Market Hypothesis

• Recall from Chapter 3 that the rate of return for any


position is the sum of the capital gains (Pt+1 – Pt)
plus
any cash payments (C):

• At the start of a period, the unknown element is the


future price: Pt+1. But, investors do have some
expectation of that price, thus giving us an
expected rate of return.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 6-2


Efficient Market Hypothesis

The Efficient Market Hypothesis views the


expectations (e) as equal to optimal forecasts (of)
using all available information. This implies:

Assuming the market is in equilibrium:


Re = R*
Put these ideas together: efficient market
hypothesis
Rof = R*

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Efficient Market Hypothesis

Rof = R*
•This equation tells us that 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.

•Financial economists state it more simply: A


security’s price fully reflects all available
information in an efficient market.

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Example 6.1: The Efficient
Market Hypothesis (a)

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Example 6.1: The Efficient
Market Hypothesis (b)

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Rationale Behind the Hypothesis

• When an unexploited profit opportunity


arises on a security (so-called because, on
average, people would be earning more than
they should, given the characteristics of that
security), investors will rush to buy until the
price rises to the point that the returns are
normal again.

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Rationale Behind
the Hypothesis (cont.)

• In an efficient market, all unexploited profit


opportunities will be eliminated.
• Not every investor need be aware of every
security and situation. As long as a few
keep their eyes open for unexploited profit
opportunities, they will eliminate the profit
opportunities that appear because in so
doing, they make a profit.

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Rationale Behind
the Hypothesis (cont.)

• Why efficient market hypothesis makes sense


If Rof > R* → Pt ↑ → Rof ↓

If Rof < R* → Pt ↓ → Rof ↑


Until Rof = R*
• All unexploited profit opportunities eliminated
• Efficient market condition holds even if there are
uninformed, irrational participants in market

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Evidence in Favor
of Market Efficiency

• Performance of Investment Analysts


and Mutual Funds should not be able to
consistently beat the market
─ The “Investment Dartboard” often beats
investment managers.
─ Mutual funds do not outperform the market on
average.

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Evidence in Favor
of Market Efficiency

• Do Stock Prices Reflect Publicly


Available Information as the EMH
predicts they will?
─ If information is already publicly available, a
positive announcement about a company will
not, on average, raise the price of its stock
because this information is already reflected in
the stock price.

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Evidence in Favor
of Market Efficiency

• Random-Walk Behavior of Stock Prices


that is, future changes in stock prices
should, for all practical purposes, be
unpredictable
─ If stock is predicted to rise, people will buy to
equilibrium level; if stock is predicted to fall,
people will sell to equilibrium level (both in
concert with EMH)
─ Thus, if stock prices were predictable, thereby
causing the above behavior, price changes would
be near zero, which has not been the case
historically
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Evidence on Efficient
Market Hypothesis
• Unfavorable Evidence
1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Market overreaction
4. Excessive volatility
5. Mean reversion
6. New information is not always immediately incorporated
into stock prices
• Overview
─ Reasonable starting point but not whole story

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Evidence Against Market
Efficiency
The Small-Firm Effect is an anomaly. Many empirical
studies have shown that small firms have earned
abnormally high returns over long periods of time,
even when the greater risk for these firms has been
considered.

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Evidence Against Market
Efficiency

• The January Effect is the tendency of stock


prices to experience an abnormal positive
return in the month of January that is
predictable and, hence, inconsistent with
random-walk behavior

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Evidence Against Market
Efficiency
• Investors have an incentive to sell stocks before
the end of the year in December because they
can then take capital losses on their tax return
and reduce their tax liability. Then when the
new year starts in January, they can repurchase
the stocks, driving up their prices and
producing abnormally high returns.

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Evidence Against Market
Efficiency
• Market Overreaction: recent research
suggests that stock prices may overreact to
news announcements and that the pricing
errors are corrected only slowly
─ When corporations announce a major change in earnings,
say, a large decline, the stock price may overshoot, and
after an initial large decline, it may rise back to more
normal levels over a period of several weeks.
─ This violates the EMH because an investor could earn
abnormally high returns, on average, by buying a stock
immediately after a poor earnings announcement and then
selling it after a couple of weeks when it has risen back to
normal levels.

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Evidence Against Market
Efficiency
• Excessive Volatility: the stock market appears to
display excessive volatility; that is, fluctuations in
stock prices may be much greater than is warranted
by fluctuations in their fundamental value.
─ Researchers have found that fluctuations in the S&P 500
stock index could not be justified by the subsequent
fluctuations in the dividends of the stocks making up this
index.
─ Other research produced a consensus that stock market
prices appear to be driven by factors other than
fundamentals.

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Evidence Against Market
Efficiency

• Mean Reversion: Some researchers have


found that stocks with low returns today
tend to have high returns in the future, and
vice versa.
─ Hence stocks that have done poorly in the past
are more likely to do well in the future because
mean reversion indicates that there will be a
predictable positive change in the future price,
suggesting that stock prices are not a random
walk.
─ Newer data is less conclusive; nevertheless,
mean reversion remains controversial.
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Evidence Against Market
Efficiency
• New Information Is Not Always Immediately
Incorporated into Stock Prices
─ Although generally true, recent evidence
suggests that, inconsistent with the efficient
market hypothesis, stock prices do not
instantaneously adjust to profit announcements.
─ Instead, 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 announcements.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 6-20


Why the EMH Does Not Imply That
Financial Markets Are Efficient

• A strong view of EMH states that (1)


expectations are rational, and (2) prices are
always correct and reflect market
fundamentals.
• This has three important implications:
─ One investment is just as good as any other
(stock picking is pointless)
─ Prices reflect all information
─ Cost of capital can be determined from security
prices, assisting in capital budgeting decisions

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Why the EMH Does Not Imply That
Financial Markets Are Efficient

• This strong view, however, is not what EMH


really means. It just means that prices are
unpredictable.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 6-22

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