Chapter # 2

Efficient Capital Market

Professor Dr. Md. Abu Sina

 Efficient Market Hypothesis (EMH)

• The efficient market hypothesis states

that at any given time, security prices
fully reflect all available information.
• Efficient Market: An efficient market is
defined as a market where there are large
numbers of rational, profit-maximizers
actively competing, with each trying to
predict future market values of individual
securities, and where important current
information is almost freely available to
all participants.
Definition of efficient capital market
It is a market in which stock prices reflect all the information
available to the market about future economic trends and
company profitability.
• The Free Dictionary by Farlex says that Efficient capital market
is a market in which new information is very quickly reflected
accurately in share prices.
Investorswords.com reflecys that it is a market where
information regarding the value of securities are incorporated
into its prices accurately and in real time. Since the value of
securities fluctuates depending on the present value of future
cash flows, an efficient capital market enables these
fluctuations to be reflected in the securities' current price.
An efficient capital market is a market where the share prices reflect new
information accurately and in real time. Capital market efficiency is judged by
its success in incorporating and inducting information, generally about the
basic value of securities, into the price of securities.
 The Efficient Markets Theory
• The efficient markets theory assumes that asset prices
(particularly stock prices) reflect all available information.
• For example, Microsoft's stock price on 08/01/2033 was
about $26 . Under the efficient markets theory, the share
price of $26 reflects all past relevant info about Microsoft
(such as their profits, sales, litigation, etc) as well as
forecasts about future earnings, sales, market share, new
products, etc. People who buy and sell Microsoft stock
have an incentive to use all of this information to make a
profit, so the price set by buyers and sellers will reflect
this information.
• Furthermore, under the efficient markets theory, a
security's return always reverts to some equilibrium
return that reflects its fundamental value, its expected
future earnings and risks. Why? Well, if Microsoft stock is
earning an abnormally high return, people will buy the
stock, bidding up the price. The higher price will drive
down the return to some equilibrium level. If Microsoft
stock is earning an abnormally low return, people will sell
the stock, driving down its price. The lower price causes
the return to rise to some equilibrium level.
• Keep in mind that not everyone needs to use all available
information to price a security for this to work. If enough
buyers and sellers are behaving rationally, then the
security price will reflect that.
 Three Forms of Market Efficiency
1. Weak form:- Prices reflect all past market information such as price and
volume.
• If the market is weak form efficient, then investors cannot earn abnormal
returns by trading on market information.
• Implies that technical analysis will not lead to abnormal returns.
• Empirical evidence indicates that markets are generally weak form
efficient.
2. Semi-strong form:- Prices reflect all publicly available
information including trading information, annual
reports, press releases, etc.
• If the market is semistrong form efficient, then
investors cannot earn abnormal returns by trading on
public information
• Implies that fundamental analysis will not lead to
abnormal returns
3. Strong form:- Prices reflect all information, including
public and private
• If the market is strong form efficient, then investors
could not earn abnormal returns regardless of the
information they possessed
• Empirical evidence indicates that markets are NOT
strong form efficient and that insiders could earn
abnormal returns.
1.The Weak Form : All past market prices and data are
fully reflected in securities prices. In other words,
technical analysis is of no use.
2.The Semi-strong Form : All publicly available information
is fully reflected in securities prices. In other words,
fundamental analysis is of no use.
3.The Strong Form Asserts : All information is fully
reflected in securities prices. In other words, even
insider information is of no use.
Technical Analysts - Investors who attempt to
identify over or undervalued stocks by
searching for patterns in past prices.
Fundamental Analysts - Analysts who
attempt to find under- or overvalued
securities by analyzing fundamental
information, such as earnings, asset values,
and business prospects.
Reaction of Stock Price to New Information in Efficient and Inefficient
Markets

Price ($) Overreaction and

correction
220 Insider
Information

180

Delayed reaction
140
Efficient market reaction

100
Days relative
–8 –6 –4 –2 0 +2 +4 +6 +7 to announcement day

Efficient market reaction: The price instantaneously adjusts to and fully

reflects new information; there is no tendency for subsequent increases and
decreases.
Delayed reaction: The price partially adjusts to the new information; 8 days
elapse before the price completely reflects the new information
Overreaction: The price over-adjusts to the new information; it “overshoots”
the new price and subsequently corrects.
• Strong Form
•insider trading
• Semi-strong form
•event studies
•mutual fund performance
•anomalies
• Weak form
•technical analysis
•serial correlation and momentum
• Weak form
•current prices reflect past prices and patterns
irrespective of the actual firm’s fundamentals
• Semi-strong form
•all public information (economic and
accounting) is reflected in stock prices
• Strong form
•all information (public and private) is reflected in
stock prices
Market Efficiency

Did you make an “Abnormal” return (AR= R-E[R])?

No Yes
Semi- Semi-
Based on: Weak Strong Strong Weak Strong Strong
Form Form Form Form Form Form
All
Relevant consistent consistent consistent ? ? inconsistent
Info
All Public
Info consistent consistent ? ? inconsistent inconsistent

Historical
Stock consistent ? ? inconsistent inconsistent inconsistent
Patterns
 Behavior of share prices
In economics and financial theory, analysts use random
walk techniques to model behavior of asset prices, in
particular share prices on stock markets, currency
exchange rates and commodity prices. This practice has
its basis in the assumption that investors act rationally
and without bias, and that at any moment they estimate
the value of an asset based on future expectations. Under
these conditions, all existing information affects the price,
which changes only when new information comes out. By
definition, new information appears randomly and
influences the asset price randomly.
• Empirical studies have demonstrated that prices do not
completely follow random walks. Low serial correlations
exist in the short term, and slightly stronger correlations
over the longer term. Their sign and the strength depend
on a variety of factors.
• Researchers have found that some of the biggest price
deviations from random walks result from seasonal and
temporal patterns. In particular, returns in January
significantly exceed those in other months (January effect)
and on Mondays stock prices go down more than on any
other day. Observers have noted these effects in many
different markets for more than half a century, but
without succeeding in giving a completely satisfactory
explanation for their persistence.
• Technical analysis uses most of the anomalies to extract
information on future price movements from historical data.
But some economists, for example Eugene Fama, argue that
most of these patterns occur accidentally, rather than as a
result of irrational or inefficient behavior of investors: the huge
amount of data available to researchers for analysis allegedly
causes the fluctuations.
• Another school of thought, behavioral finance, attributes non-
randomness to investors' cognitive and emotional biases. This
can be contrasted with fundamental analysis.
• When viewed over long periods, the share price is directly
related to the earnings and dividends of the firm. Over short
periods, especially for younger or smaller firms, the
relationship between share price and dividends can be quite
unmatched.
Causes of Stock Price Change
Stock prices change every day as a result of market forces. By
this we mean that share prices change because of supply
and demand.
If more people want to buy a stock (demand) than sell it
(supply), then the price moves up. Conversely, if more
people wanted to sell a stock than buy it, there would be
greater supply than demand, and the price would fall.
Understanding supply and demand is easy.
What is difficult to comprehend is what makes people like a
particular stock and dislike another stock. This comes down
to figuring out what news is positive for a company and
what news is negative. There are many answers to this
problem and just about any investor you ask has their own
ideas and strategies.
The principal theory is that the price movement of a
stock indicates what investors feel a company is
worth.
Don't equate a company's value with the stock price.
The value of a company is its market capitalization,
which is the stock price multiplied by the number of
shares outstanding.
For example, a company that trades at $100 per share
and has 1 million shares outstanding has a lesser
value than a company that trades at $50 that has 5
million shares outstanding ($100 x 1 million = $100
million while $50 x 5 million = $250 million).
Market Capitalization: A measure of the value of a company, calculated
by multiplying the number of outstanding shares by the current price
per share.
For example, a company with 100 million shares of stock outstanding and
a current market value of $25 a share has a market capitalization of $2.5
billion.
To further complicate things, the price of a stock doesn't only reflect a
company's current value, it also reflects the growth that investors expect
in the future.
 How Do Stock Prices Work?
Stock prices appear to behave randomly to many who view
price behavior on a stock chart. When you view a price
chart, what you are really looking at is supply and demand
in action. Investors tend to behave like a school of fish. As
fish move in unison, so do investors, as they respond to
forces that create either supply or demand for stocks.

Stock prices are driven

primarily by human
psychology and company
fundamentals.
1. Supply and Demand: The law of demand, as related to the
stock market, states that as a stock price falls, demand for that
stock rises. When demand becomes strong enough, the price
will stop falling and begin rising. Likewise, the law of supply
states that when the stock price rises, more people are willing
to sell it. When enough sellers are willing to sell, the price will
stop rising and eventually begin to fall lower.
2. Earnings: Stock supply and demand does not occur in a
vacuum. Something has to drive people to buy or sell stocks.
One of the biggest factors that creates supply and demand are
company earnings. As a company's earnings rise, demand for
its stock increases as investors perceive greater value in
owning it. If earnings are below investor expectations, they
will sell, creating supply.
3. Emotion: Investors are people and people are emotional
beings. As such, the emotions of fear and greed can have a big
impact on price supply and demand. When investors, behaving
like a school of fish, become greedy, stock prices will rise as
they are willing to pay higher and higher prices. Falling prices
can cause investors to become fearful, causing them to sell
lower and lower. In both instances, eventually, the laws of
supply and demand will cause the price to turn higher or
lower again.
4. The Economy and Other Factors: Earnings and emotion are
arguably the two biggest price movers in the market, but stock
prices reflect a large number of other factors as well.
Economic outlook can impact company earnings, so the
economy will impact stock prices. Other factors include
analyst outlooks, major events in the world (such as terrorist
attacks), oil prices, inflation and many others.
 The Six Lessons of Market Efficiency

Lesson 1: Markets have no memory (don't wait for recent price changes to be
reversed; they probably will not be)
Lesson 2: Trust market prices (more than your own hunches)
Lesson 3: Look at market prices in detail to predict the future (term structure;
market's unfavorable assessment of Viacom's takeover of Paramount; for the
market price implicitly weights a lot of people's serious assessments)
Lesson 4: Do not believe in financial
illusions (dividends and stock splits; stock
prices run up before a split)
Lesson 5: Value is lost when the company
does something that a
shareholder can do on his own for smaller
transaction costs
Lesson 6: Demands for stocks should be
highly, highly elastic.
Some Lessons from Capital Market
1. Average Returns: The First Lesson
Risk, Return and Financial Markets-
• Lessons from capital market history
• There is a reward for bearing risk
• The greater the potential reward, the greater the risk
• This is called the risk-return trade-off
Dollar Returns-Total dollar return = income from investment + capital gain
(loss) due to change in price.
Example:
• You bought a bond for $950 one year ago. You have received two coupons of $30
each. You can sell the bond for $975 today. What is your total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 975 – 950 = 25
• Total dollar return = 60 + 25 = $85
Percentage Returns- It is generally more intuitive to think in
terms of percentages than in dollar returns.
• Dividend yield = income / beginning price.
• Capital gains yield = (ending price – beginning price) /
beginning price.
• Total percentage return = dividend yield + capital gains yield.
• Example – Calculating Returns
You bought a stock for $35 and you received dividends of $1.25.
The stock is now selling for $40.
• What is your dollar return?
• Dollar return = 1.25 + (40 – 35) = $6.25
• What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%
2. The Variability of Returns: The Second
Lesson
• Variance and standard deviation measure the volatility of asset returns.
• The greater the volatility, the greater the uncertainty
• Historical variance = sum of squared deviations from the mean / (number of
observations – 1)
• Standard deviation = square root of the variance
Risk Premiums
•The “extra” return earned for taking on
risk.
•Treasury bills are considered to be risk-
free.
•The risk premium is the return over and
above the risk-free rate.
 Efficient Market and Regulations
Regulations are an absolute necessity in the face of the
growing importance of capital markets throughout the
world. The development of a market economy is
dependent on the development of the capital market.
The regulation of a capital market involves the regulation
of securities; these rules enable the capital market to
function more efficiently and impartially.
A well regulated market has the potential to encourage
additional investors to partake, and contribute in,
furthering the development of the economy.
Capital Market Regulatory Authorities
Worldwide
The chief capital market regulatory authorities worldwide
are as follows:
• U.S. Securities and Exchange Commission
• Canadian Securities Administrators, Canada
• Australian Securities and Investments Commission
• Securities and Exchange Commission, Pakistan
• Securities and Exchange Board of India
• Bangladesh Securities and Exchange Commission (BSEC)
• Securities and Exchange Surveillance Commission
• Securities and Futures Commission, Hong Kong
• Financial Supervision Authority, Finland
• Financial Supervision Commission, Bulgaria
• Financial Services Authority, UK
• Comision Nacional del Mercado de Valores, Spain
• Authority of Financial Markets
Thanks for Patience
Hearing