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    Efficient Market Hypothesis: The Collective Wisdom

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    hitesh dave
    The document discusses the efficient market hypothesis, which proposes that market prices reflect all available information. It defines three levels of market efficiency and reviews empirical evidence supporting weak and semi-strong forms of efficiency. While the hypothesis has limitations, there is no clear better alternative currently. The implications are that technical analysis may not be useful while unconventional analysis could find market inefficiencies.

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    Efficient Market Hypothesis: The Collective Wisdom

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    hitesh dave
    16 views18 pages
    The document discusses the efficient market hypothesis, which proposes that market prices reflect all available information. It defines three levels of market efficiency and reviews empirical evidence supporting weak and semi-strong forms of efficiency. While the hypothesis has limitations, there is no clear better alternative currently. The implications are that technical analysis may not be useful while unconventional analysis could find market inefficiencies.

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    The document discusses the efficient market hypothesis, which proposes that market prices reflect all available information. It defines three levels of market efficiency and reviews empirical evidence supporting weak and semi-strong forms of efficiency. While the hypothesis has limitations, there is no clear better alternative currently. The implications are that technical analysis may not be useful while unconventional analysis could find market inefficiencies.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    16 views18 pages

    Efficient Market Hypothesis: The Collective Wisdom

    Uploaded by

    hitesh dave
    The document discusses the efficient market hypothesis, which proposes that market prices reflect all available information. It defines three levels of market efficiency and reviews empirical evidence supporting weak and semi-strong forms of efficiency. While the hypothesis has limitations, there is no clear better alternative currently. The implications are that technical analysis may not be useful while unconventional analysis could find market inefficiencies.

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    You are on page 1of 18

    Chapter 9

    EFFICIENT MARKET HYPOTHESIS


    The Collective Wisdom
    OUTLINE
    • Random Walk
    • What is an Efficient Market
    • Empirical Evidence on Weak-form Efficient Market
    Hypothesis
    • Empirical Evidence on Semi-strong Form Efficient
    Market Hypothesis
    • Empirical Evidence on Strong-form Efficient Market
    Hypothesis
    • What is the Verdict
    • Implications for Investment Analysis
    Random Walk
    • Maurice Kendall found that stock prices followed a
    random walk, implying that successive price changes
    are independent of one another.

    • A number of researchers have employed ingenious


    methods to test the randomness of stock price
    behaviour.

    • Academic researchers concluded that the randomness


    of stock prices was the result of an efficient market.
    What Is An Efficient Market
    • AN EFFICIENT MARKET IS ONE IN WHICH THE
    MARKET PRICE OF A SECURITY IS AN
    UNBIASED ESTIMATE OF ITS INTRINSIC VALUE

    • MARKET EFFICIENCY IS DEFINED IN RELATION


    TO INFORMATION THAT IS REFLECTED IN
    SECURITY PRICES. FAMA DISTINGUISHES
    THREE LEVELS OF MARKET EFFICIENCY.

    • Weak-form efficiency
    • Semi-strong form efficiency
    • Strong-form efficiency
    Stock Market Efficiency

    STRONG
    SEMI-STRONG
    WEAK

    MISCONCEPTIONS
    1. EMH.. IMPLIES… MARKET HAS PERFECT FORECASTING.
    2. AS PRICES TEND TO FLUCTUATE THEY CANNOT
    REFLECT FAIR VALUE.
    3. INABILITY OF INSTITUTIONAL PORTFOLIO MANAGERS
    TO ACHIEVE SUPERIOR INVESTMENT PERFORMANCE
    IMPLIES THAT THEY LACK COMPETENCE.
    4. THE RANDOM MOVEMENT OF STOCK PRICES SUGGESTS
    THAT THE STOCK MARKET IS IRRATIONAL.
    Empirical Evidence On Weak-Form Efficient
    Market Hypothesis

    • SERIAL CORRELATION TEST

    • RUNS TEST

    • FILTER RULES TEST


    Empirical Evidence On Semi-Strong Efficient
    Market Hypothesis

    • POSSIBLE TO EARN SUPERIOR RISK-ADJUSTED

    RETURN BY TRADING ON INFORMATION


    EVENTS? (EVENT STUDY)

    • POSSIBLE TO EARN SUPERIOR RISK-ADJUSTED


    RETURN … BY TRADING ON AN OBSERVABLE
    CHARACTERISTIC OF A FIRM? (PORTFOLIO
    STUDY)
    Event Study
    1. IDENTIFY THE ANNOUNCEMENT DATE OF THE EVENT
    ANNOUNCEMENT DATE

    2. COLLECT RETURNS DATA AROUND THE ANNOUNCEMENT


    DATE
    Rj -n Rj,O Rj, +n

    -n TO +n
    3. CALCULATE THE EXCESS RETURN
    ERj t = Rj t - BETAj x Rmt

    4. COMPUTE THE AVERAGE AND THE STANDARD ERROR OF


    EXCESS RETURNS ACROSS ALL FIRMS
    5. ASSESS WHETHER THE EXCESS RETURNS AROUND THE
    ANNOUNCEMENT DATE ARE DIFFERENT FROM ZERO
    AVERAGE EXCESS RETURN
    T STATISTIC FOR EXCESS
    Gradual Adjustments To
    Earnings Announcements
    Portfolio Study
    1. DEFINE THE VARIABLE (CHARACTERISTIC) ON
    WHICH FIRMS WILL BE CLASSIFIED
    2. CLASSIFY FIRMS INTO PORTFOLIOS BASED UPON
    THE MAGNITUDE OF THE VARIABLE
    3. COMPUTE THE RETURNS FOR EACH PORTFOLIO
    4. CALCULATE THE EXCESS RETURNS FOR EACH
    PORTFOLIO
    E Rji = Rji - BETAj x RMt
    5. ASSESS WHETHER THE AVERAGE EXCESS
    RETURNS ARE DIFFERENT ACROSS THE
    Returns By P - E Multiple Class

    18.00%
    16.00%
    14.00%
    12.00%
    10.00%
    8.00%
    6.00%
    4.00%
    2.00%

    0.00%
    LOWEST 2 3 4 5 6 7 8 9
    HIGHEST
    Empirical Evidence On Strong-Form
    Efficient Market Hypothesis

    EMPIRICAL EVIDENCE BROADLY SUGGESTS THE


    FOLLOWING:

    • CORPORATE INSIDERS EARN SUPERIOR


    RETURNS, AFTER ADJUSTMENT FOR RISK.

    • MUTUAL FUND MANAGERS, ON AVERAGE, DO


    NOT EARN SUPERIOR RETURNS AFTER
    ADJUSTMENT FOR RISK.
    Other Evidence

    • PRICE OVERREACTIONS

    • CALENDAR ANOMALIES

    • EXCESS VOLATILITY

    • NORMAL RANGE OF INTEREST


    The Crash Of 1987
    OCTOBER 19, 1987 DJIA 23%
    P ≃ IV APPEARS LESS APPEALING
    DIFFICULTY . . VALUING EQUITIES …
    3
    100 =
    0.16 - 0.13
    3
    75 =
    0.16 - 0.12
    DIFFICULTY IN VALUING EQUITY STOCKS … TWO IMPLICATIONS :
    1. INVESTORS TYPICALLY PRICE AN EQUITY STOCK IN RELATIVE
    TERMS
    2. ALMOST IMPOSSIBLE . . TEST THE HYPOTHESIS … P ≃ IV
    ABSOLUTE EFFICIENCY
    VS
    RELATIVE EFFICIENCY
    Verdict
    • TRUE, THE EFFICIENT MARKET HYPOTHESIS, LIKE
    ALL THEORIES, IS AN IMPERFECT AND LIMITED
    DESCRIPTION OF THE STOCK MARKET. HOWEVER,
    THERE DOES NOT, AT LEAST FOR THE PRESENT,
    SEEM TO BE A BETTER ALTERNATIVE.

    • MERTON MILLER : “IT IS CLOSER TO BEING A


    ‘PARADIGM’ THAN A MERE HYPOTHESIS, BRINGING
    A COMMON AND COHERENT EXPLANATORY
    FRAMEWORK TO A WIDE VARIETY OF SEEMINGLY
    UNRELATED PHENOMENA. LIKE ALL SCIENTIFIC
    PARADIGMS, IT WILL SURVIVE UNTIL DISPLACED
    BY A BETTER ONE. AT THE MOMENT, AT LEAST NO
    BETTER PARADIGM IS IN SIGHT”
    Implications For Investments
    • Substantial evidence in favour of randomness suggests that
    technical analysis is of dubious value.
    • Routine and conventional fundamental analysis is not of
    much help in identifying profitable courses of action
    • The key levers for earning superior rates of returns are:
    • Early action on any new development.
    • Sensitivity to market imperfections and anomalies.
    • Use of original, unconventional, and innovative modes
    of analysis.
    • Access to inside information and its sensible
    interpretation
    • An independent judgment that is not affected by
    market psychology.
    SUMMING UP
    • Stock prices appear to follow a random walk. The
    randomness of stock prices is the result of an efficient
    market
    • It is useful to distinguish three levels of market efficiency :
    weak form efficiency, semi-strong form efficiency, and
    strong form efficiency.
    • The weak form efficient market hypothesis says that the
    current price of a stock reflects all information found in
    the record of past prices and volumes.
    • The semi-strong form efficient market hypothesis holds that
    stock prices adjust rapidly to all available public
    information.
    • The strong form efficient market hypothesis holds that all
    available information, public and private is reflected in
    stock prices.
    • Empirical evidence seems to provide strong support for
    weak-form efficiency, mixed support for semi-strong form
    efficiency, and weak support for strong-form efficiency.
    • The efficient market hypothesis is an imperfect and
    limited description of the stock market. however, at least
    for the present, there does not seem to be a better
    alternative.
    • The key implications of the efficient market hypothesis are
    that technical analysis is of dubious value and routine
    fundamental analysis is not of much help.

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