Market Efficiency

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 10 Market Efficiency
Prepared by Ken Hartviksen
CHAPTER 10 Market Efficiency
Lecture Agenda
Learning Objectives Important Terms The Importance of Market Efficiency Market Efficiency Defined The Efficient Market Hypothesis Empirical Evidence Regarding Market Efficiency Implications of EMH Summary and Conclusions
Concept Review Questions
10 - 3
Learning Objectives
1. 2. 3. 4. What is meant by market efficiency How to differentiate among different levels of efficiency How to use the concepts in this chapter to judge the appropriateness of corporate decisions How the concepts in this chapter are used in regulating market activity
10 - 4
Important Chapter Terms

Abnormal returns Allocational efficiency Anomalies Buy side analysts Disclosure Efficient market Efficient market hypothesis (EMH) Event study Informational efficiency Material facts Momentum
Operational efficiency Random walk hypothesis Securities law Sell side analysts Semi-strong form efficient market hypothesis Size effect Strong form efficient market hypothesis Technical analysis Weak form efficient market hypothesis
10 - 5
The Importance of Market Efficiency

Market Efficiency

Understanding the If and How the EMH Principal can Affect Shareholder Wealth
Understanding how securities are valued is important because these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders. It is the legal requirement and managerial responsibility for managers to act in the owners best interest. The discount rate that represents shareholders required rate of return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk premium. A question remainsDO MARKET PRICES REFLECT THE ACTIONS OF MANAGERS?
If they do, then managers must learn what actions they should take in order to fulfill their legal and managerial responsibilities to shareholders.
CHAPTER 10 Market Efficiency 10 - 7

Three Elements to Market Efficiency
Operational Efficiency
Transactions costs are low, thereby enhancing trading of securities
Allocational Efficiency
There are enough securities to efficiently allocate risk
Informational Efficiency
Market prices fairly and quickly reflect all available information.
10 - 8

Informational Efficiency
Informational Efficiency is the focus of this chapter. The closer the link between actions of managers and the value of the firm, the more informationally efficient the capital market.
10 - 9

Securities Laws Affecting Public-Issuers of Securities Securities laws in Canada reflect the belief that there is (or should be) a strong connection between information and stock prices and these laws reflect a number of common principles related to parties to transactions and access to information:
Continuous disclosure of all material information about the firm.
Publicly-traded firms fulfill this responsibility through publication of annual audited financial statements, unaudited quarterly financial statements, and through timely press releases and announcements of anything that could materially affect the share price of the firm.
Fair and equal treatment of all market participants through disclosure requirements that ensure all participants have simultaneous access to the same information about publicly-traded firms.
The use of cease-trading orders when new information is being released to the market is an example of how regulators ensure that information is widely disseminated to all market participants before trading is allowed to occur. In this way, all market participants are trading on the basis of the same and complete information ensuring that some participants do not have an informational advantage over others.
Asymmetric Information
Asymmetric information is when one party to a transaction has access to more a complete and accurate set of facts than the other party.
When this condition exists, it is possible for the party with better information to use that at their own personal gain, and at the expense of the other.
10 - 11
Asymmetric Information
An Example The Used Car! An example of Asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private transaction.
The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problems. The buyer (presuming no expertise as a mechanic) has only their limited skills of observation and investigation to inform their purchase decision.
In the foregoing example, it is possible, in the absence of rules and regulations, for the seller to take advantage of the buyer because of information asymmetry. This means, the buyer is likely to pay more for the car than they should! The seller reaps the rewards of superior information.
In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation. This package will include an estimate of wholesale and retail price of the used car, and a list of past owners. This is an example of government regulation to try to reduce the information advantage sellers have over buyers.
Disclosure and Market Efficiency

The Asymmetric Information Challenge
If informational advantages were widely permitted, and if there were a persistent advantage of some market participants over others, the credibility of the markets would be shaken. Under such circumstances, many people would choose not to invest in securities, choosing, instead to put their money into managed deposits, or worse, choosing to hide their money under a pillow. This would significantly reduce the number of market participants, and the amounts of money invested in the markets. The result would be:
Less market efficiency and even fewer willing participants! Lower security prices in general Infrequent trading of securities Increasing ability of one market participant to affect the security price through their actions.
Ultimately, the capital market would not be able to channel sufficient surplus funds to underwrite economic activity such as plant expansions, research and development, etc. In the end, companies would lack capital, and increasingly become inefficient and ineffective in their markets. Jobs would be lost and the standard of living of all would decline.
10 - 13
Defining Market Efficiency

What is an Efficient Market?
An Efficient Market
Is a market that reacts quickly and relatively accurately to new public information, which results in prices that are correct, on average.
10 - 14
Market Efficiency
Requisite Conditions
For markets to operate efficiently some conditions must exist:

1. A large number of rational, profit-maximizing investors exist, who actively participate in the market by analyzing, valuing, and trading securities. The markets must be competitive, meaning no one investor can significantly affect the price of the security through their own buying or selling. 2. Information is costless and widely available to market participants at the same time. 3. Information arrives randomly and therefore announcements over time are not serially connected. 4. Investors react quickly and fully (and reasonably accurately) to the new information, which is reflected in stock prices.
10 - 15
Efficient Market Hypothesis (EMH)

Defined
The Efficient Market Hypothesis is The theory that markets are efficient and therefore, in its strictest sense, implies that prices accurately reflect all available information at any given time.
10 - 16

Weak Form EMH
The theory that security prices reflect all market data, referring to all past price and volume trading information.
Implication:
If Weak Form efficient, historical trading data will already be reflected (discounted) in current prices and should be of no value in predicting future price changes.

Semi-strong Form EMH
The theory that all publicly known and available information is reflected in security prices. Assumes the weak-form set of information as well as all public information pertinent to the security such as:
Earnings Dividends Corporate investments, Management changes
Implication:
If semi-strong efficient, it is futile to analyze public information such as earnings projections and financial statements in an attempt to identify underpriced or overpriced securities.

Strong Form EMH
The theory that stock prices fully reflect all information, which includes both public and private information.
Implications:
Stock prices are fairly priced. It is not possible to use public information to identify over-priced or under-priced stocks It is not possible to use insider information to identify over-priced or under-priced stocks
Empirical Tests of the EMH

Market Efficiency

Tests of EMH
All tests of the EMH try to demonstrate that using a particular source of information allows an investor to consistently earn abnormal returns. Abnormal returns are percentage returns that are greater than a nave buy-and-hold strategy where the investor passively buying a market index portfolio such as the S&P/TSX 60 composite index.
In other words, can an active investment strategy, using a particular trading rule or source of information, generate greater risk-adjusted returns than a passive, nave, yet achievable, investment strategy?
Empirical Evidence on Market Efficiency

Anomalies
Anomalies are exceptions to a rule or theory

An identified anomaly may not violate the theory, especially if it cannot be exploited profitably after transactions costs and taxes, or if it cannot be exploited consistently.
10 - 22
Weak Form of the EMH

Market Efficiency
Weak Form EMH

States that security prices fully reflect all market data
All past price and trading volume data
If markets are weak form efficient historical trading data will already be reflected in current prices and should be of no value in predicting future price changes.
10 - 24

Weak Form Evidence
The Random Walk Hypothesis states prices follow a random walk with price changes over time being independent of one another.
This hypothesis is logical if information arrives randomly, as it should, and if investors react quickly to it.
Tests of weak form efficiency include:

Serial correlation tests Runs (or signs tests) Testing of trading rules used by technical analysts

Weak Form Evidence - Anomalies
Anomalies that contest weak form market efficiency are:

Investors have been found to overreact to new information and this leads to stock prices over-shooting and undershooting their intrinsic value and this results in stock price reversals favouring in some cases, contrarian trading strategies Evidence of momentum in stock returns (See Figure 10-1 found on the following slide that identify winner (most recent six month period), loser portfolios and performance of S&P/TSX Composite Index) Evidence of seasonal patterns in stock returns including the January effect, the January effect for smaller firms, the day-ofthe week effect (average negative Monday returns statistically different than the other trading days of the week), and the tendency for returns to be higher on the last trading day of each month.
10 - 26
Weak Form Evidence

Momentum in Canadian Stock Returns, 1980 - 1999
10 - 1 FIGURE
January 1980 December 1999 Six-Month Holding Period Returns (%)
25 20 15 10 5 0
20.7 6
14.75
5.9 9
6.10
Top 30
Bottom 30
Top-Bottom
TSX
10 - 27

Weak Form Evidence - Conclusion
The anomalies identified are very difficult and risky to exploit:

Transactions costs reduce or eliminate the economic advantage The anomalies dont happen consistently enough to make them a reliable source of abnormal returns In conclusion, the capital markets appear to be weak form efficient.
10 - 28
Semi-Strong Form of the EMH

Market Efficiency
Semi-Strong Form of EMH

States that all publicly known and available information is reflected in security prices. This includes information about:
Earnings Dividends Corporate investments Management changes, etc.
A market that quickly incorporates newly released information (to the public) is semi-strong efficient.
10 - 30
Empirical Evidence on Semi-strong Efficiency

Semi-Strong Form Evidence
Tests of the Semi-strong Form of EMH include:

Event (announcement) studies including earnings surprises and corporate announcements to examine the impact of particular events on stock prices Examination of the performance of investors to see if they can use publicly available information to consistently generate abnormal returns
10 - 31

Event Studies
Event studies examine stock returns to determine the impact of a particular event on stock prices, in particular, what happens to the stock price, before, during and following the event.
Events include:
Company-specific announcements such as stock splits, takeover announcements, dividend changes, accounting changes. Economy-wide changes such as unexpected interest rate changes
Figure 10 2 (on the following slide) illustrates the price adjustment process for:
(A) an efficient market (B) - overreaction in an efficient market (C) - slow reaction in an efficient market
10 - 32

Efficient (A) and Inefficient Markets (B) and (C)
10 - 2 FIGURE
Stock Price
B A
$23
$20
t
Announcement Date
Time
10 - 33

Typical Event Study Results
Most event studies have shown that stock prices change before the announcement as demonstrated in Figure 10 3 on the following slide. These results demonstrate that an investor cannot move quickly enough at the time an event occurs (announcement is made) to profit from the change, so this speaks to market efficiency in the semi-strong form,
On the other hand This evidence does not provide support for the strong form of the EMH because some investors are profiting from private information about impending price changes.
Empirical Evidence on Semi-strong EMH

Typical Event Study Result for Good News Event
10 - 3 FIGURE
Stock Price
B A
$23
$20
t
Announcement Date
Time
10 - 35
Semi-strong Anomalies
Earnings Surprises
Several studies have confirmed a lag exists when earnings either exceed or fall short of consensus earnings estimates.
Largest positive earnings surprises displayed superior subsequent performance Low or negative earnings surprises displayed poor subsequent performance
The substantial adjustments after the announcement date contradicts the semi-strong form of the EMH
10 - 36
Semi-strong Anomaly Tests on Investors

These are tests to determine whether investors can use publicly-available information to obtain abnormal returns. The strongest evidence of semi-strong market efficiency is the fact that professional fund managers with all the training, expertise, technological capability and access to data DO NOT OUTPERFORM THE MARKET ON A RISK-ADJUSTED BASIS, on average. After expenses, average professional fund manager performance is substantially worse than their performance benchmarks (by as much as 50 to 200 basis points)
10 - 37
Semi-strong Anomaly Tests on Investors

Investment Styles
Tests to determine whether investors can use publiclyavailable information to obtain abnormal returns have shown that value investment styles have consistently outperformed growth styles. Value stocks are those that have:
below-average price-to-earnings (P/E) and market-to-book (M/B) ratios, and above-average dividend yields
Growth stocks are those that investors are prepared to pay a premium price for because expected future growth in earnings and share price and have:
above-average P/E and M/B ratios, and below-average dividend yields
(Figure 10 4 on the following slide depicts the relative performance of the two investment styles from 1982 to 2006)

Growth and Value Stocks in Canada
FIGURE 10-4
10 - 39
Small Firm Effect
Figure 10 5 (found on the following slide) depicts the returns on Canadian small cap stocks versus the broad market. Over this period small caps outperformed the broader index providing an annual return of 16.25% versus 11.91%.
Smaller cap stock returns are much more volatile (24.8% versus 15.12%), and Transactions costs are greater for small cap stocks
Therefore, attempting to capitalize on the small firm effect is not a free lunch
10 - 40
Empirical Evidence on Semi-strong EMH

S&P/TSX Composite Index versus Small Cap Stocks in Canada
FIGURE 10-5
10 - 41
Value Line Investment Survey Effect
Value Line Investment Survey is a widely followed stock publication that ranks a large universe of stocks from 1 (best) to 5 (worst)
Substantial evidence suggests that stocks ranked 1 or 2 experience superior performance over the following 12 monthsand those in lower-ranked categories perform poorly.
These findings contradict the semi-strong EMH However, again, transactions costs make it difficult to profit from this anomaly.

Semi-Strong Form Evidence - Conclusions
Most studies support the Semi-strong Form of the EMH A number of anomalies (or exceptions) have been identified including:
The Value investment style has consistently outperformed the growth style The size effect that shows that small market cap stock tend to outperform large cap stocks on a riskadjusted return basis The Value Line Investment Survey effect
Strong Form of the EMH

Market Efficiency
Empirical Evidence on Strong Form Efficiency

Strong Form Evidence
The strong form asserts that prices reflect all public and private information. If a market is strong-form efficient, then insiders could not profit from inside information not known by the public. Tests of this hypothesis include determining whether any group of investors has information that allows them to earn abnormal profits consistently.
Several studies found consistent abnormal profits Others found only slightly better than average returns.
10 - 45
Empirical Evidence on Strong Form Efficiency

Strong Form Evidence - Conclusions
On balance, evidence does not support the strong form of the EMH.
It should be noted that insider trading laws do restrict the ability of insiders to act and therefore, profit from their inside information, so this is one reason why evidence may be muted regarding the degree of advantage insiders enjoy under current law.
10 - 46
Summary of Empirical Evidence
1. Weak form efficiency is very well supported, and it is reasonable to conclude that markets are weak form efficient, although a few anomalies do exist. 2. Semi-strong form efficiency is well supported; however, more contradictory evidence exists for this version of the EMH than for the weak form. 3. Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest sense.
Implications of Market Efficiency

Market Efficiency

Empirical Evidence suggests:
Markets reach quickly and relatively accurately to new public information Market prices are correct on average
Markets may not be perfectly efficient, but they are relatively efficient.
10 - 49

Implications for Investors
1. Technical analysis is not likely to be rewarded. 2. Fundamental analysis is also unlikely to be successful at generating abnormal profits after transactions costs, research costs and taxes. 3. Active trading strategies are unlikely to outperform passive buy-and-hold strategiesfavouring index mutual funds or exchange-traded funds (ETFs) 4. Investors should focus on the basics of good investing by defining investment goals in terms of expected return and acceptable risk levels.

Implications for Corporate Officers
1. Timing of security issues or share repurchases in unimportant because prices are correct on average. 2. Management should monitor the price of the firms securities to see whether price changes reflect new information or short-run momentum and/or overreaction.
10 - 51
Summary and Conclusions

In this chapter you have learned:
That an efficient market is one that reacts quickly and relatively accurately to new information, and therefore its prices are correct on average. That the Efficient Market Hypothesis (EMH) is tested in three forms; weak, semi-strong and strong. That empirical evidence suggests that markets are reasonably efficient, but not perfectly so. Investors and corporate officers should modify their behaviours and expectations in light of the evidence of market efficiency.
10 - 52
Concept Review Questions

Market Efficiency
Concept Review Question 1

Different Types of Market Efficiency
What is the difference between the various types of market efficiency?
10 - 54
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.
10 - 55

Market Efficiency

Uploaded by

Copyright:

Available Formats

Market Efficiency

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Market Efficiency

Uploaded by

Copyright:

Available Formats

INTRODUCTION TO

Prepared by Ken Hartviksen

CHAPTER 10 Market Efficiency

CHAPTER 10 Market Efficiency

CHAPTER 10 Market Efficiency

Important Chapter Terms

CHAPTER 10 Market Efficiency

The Importance of Market Efficiency

The Importance of Market Efficiency

The Importance of Market Efficiency

CHAPTER 10 Market Efficiency

The Importance of Market Efficiency

CHAPTER 10 Market Efficiency

The Importance of Market Efficiency

CHAPTER 10 Market Efficiency

Disclosure and Market Efficiency

Defining Market Efficiency

CHAPTER 10 Market Efficiency

For markets to operate efficiently some conditions must exist:

CHAPTER 10 Market Efficiency

Efficient Market Hypothesis (EMH)

CHAPTER 10 Market Efficiency

Efficient Market Hypothesis (EMH)

Efficient Market Hypothesis (EMH)

Efficient Market Hypothesis (EMH)

Empirical Tests of the EMH

Efficient Market Hypothesis (EMH)

Empirical Evidence on Market Efficiency

Anomalies are exceptions to a rule or theory

CHAPTER 10 Market Efficiency

Weak Form of the EMH

Weak Form EMH

CHAPTER 10 Market Efficiency

Empirical Evidence on Market Efficiency

Tests of weak form efficiency include:

Empirical Evidence on Market Efficiency

Anomalies that contest weak form market efficiency are:

Weak Form Evidence

CHAPTER 10 Market Efficiency

Empirical Evidence on Market Efficiency

The anomalies identified are very difficult and risky to exploit:

CHAPTER 10 Market Efficiency

Semi-Strong Form of the EMH

Semi-Strong Form of EMH

Empirical Evidence on Semi-strong Efficiency

Tests of the Semi-strong Form of EMH include:

CHAPTER 10 Market Efficiency

Empirical Evidence on Semi-strong Efficiency

CHAPTER 10 Market Efficiency

Empirical Evidence on Semi-strong Efficiency

CHAPTER 10 Market Efficiency

Empirical Evidence on Semi-strong Efficiency

Empirical Evidence on Semi-strong EMH

CHAPTER 10 Market Efficiency

CHAPTER 10 Market Efficiency

Semi-strong Anomaly Tests on Investors

CHAPTER 10 Market Efficiency

Semi-strong Anomaly Tests on Investors

Empirical Evidence on Semi-strong Efficiency