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Market Efficiency

Market Efficiency. What is an efficient market? The Efficient Market Hypothesis Technical Analysis Fundamental Analysis Tests of EMH. What is an efficient market?. Prices reflect all relevant information Prices adjust rapidly to new information Why should capital markets be efficient?

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Market Efficiency

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  1. Market Efficiency • What is an efficient market? • The Efficient Market Hypothesis • Technical Analysis • Fundamental Analysis • Tests of EMH

  2. What is an efficient market? • Prices reflect all relevant information • Prices adjust rapidly to new information • Why should capital markets be efficient? • Many competing analysts valuing securities independently • new information arrives randomly

  3. Efficient Market Hypothesis • Weak form: • prices already reflect all information contained in past prices (and other historical data) • Semistrong form: • prices reflect all publicly available information • Strong form: • prices reflect all relevant information including inside information

  4. Technical Analysis • Market value determined solely by supply and demand • S&D governed by rational and irrational factors • Prices tend to move in trends that persist • Trends change due to shifts in S&D and can be detected

  5. Technical Analysis • No reliance on Financial Statements • Accounts for psychological factors • Implies that markets are not efficient

  6. Testing Market Efficiency • Weak form: • autocorrelation testsRt = a + bRt-1 + cRt-2 + dRt-3 + . . . • runs tests+++-+--++-+---+-++++--+--++ • filter rulesIf 5%, sell and short; if 5%, cover and buy

  7. Testing Market Efficiency • Semistrong form: • Event studiesAbnomal return = Actual - ExpectedExpected return = forecast • rit = ai + birmt + eit • ARit = eit • CAR = Cumulative abnormal return • Examples

  8. Anomalies • Small firm effect • January effect • Neglected firm effect • Market-to-Book ratios • Reversals (Overreaction) • Day of the week • Weather

  9. Testing Market Efficiency • Strong form: • Insider trading • Specialists • Mutual Fund rankings

  10. Are Markets Efficient? • It’s not a “yes or no” question. • Anomalies indicate that it’s not perfectly efficient • Evidence supports semistrong form • Markets are very efficient

  11. PM Implications? • Have superior analysis skills? • Exploit it! • Attend to anomalies • No superiority of analysis? • Determine and quantify risk preferences • Concentrate on allocation between risky assets and risk free alternative • Diversify • Rebalance to maintain desired risk exposure • Minimize total transaction costs

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