Market Efficiency

1
Market Efficiency

• Why does the price of a security change?
• Time Value of Money.
• Changes in expectations about the timing, size,
  or risk of the cash flows.
• Why would expectations change?
• New information becomes available modifying our
  view of the uncertain future.
• Market Efficiency is concerned with how well
  prices reflect information.
• In an efficient market the prices should be
  unbiased estimates of discounted future values.

2
Abnormal vs. Expected Returns

• Realized returns are simply the percentage change
  in asset value.
• Abnormal returns are the realized returns in
  excess of the return expected for a level of
  risk.

3
Forms of Market Efficiency

• An efficient market will quickly and accurately
  reflect available information.
• The definition of available information gives
  three forms of efficiency
• Weak Form - Prices reflect all information
  reflected in past prices and volumes.
• Semi-Strong Form - Prices reflect all public
  information.
• Strong Form - Prices reflect all public and
  private information.

4
Weak Form Efficiency

• Says you can not make abnormal returns on the
  basis of historical data.
• Rules out Technical Analysis
• Some trading strategies do make an abnormal
  return before trading costs, but not once trading
  costs are included.
• Empirical evidence generally supports Weak Form
  Efficiency.

5
Semi-Strong Form Efficiency

• No abnormal returns on the basis of any public
  information (including historical data).
• Implies that Fundamental Analysis will not
  provide excess returns.
• Does not mean Fundamental Analysis is useless.
  Without it markets may not be as efficient.
• Evidence generally supports Semi-Strong Form
  Efficiency, although this is the subject of
  considerable debate.

6
Strong Form Efficiency

• Says that there is no information at all that
  would allow an abnormal profit.
• Implies that even insiders with special knowledge
  (e.g., an forthcoming acquisition announcement)
  can not make an abnormal profit.
• Not much support for Strong Form. The fact that
  there are regulations against insider trading
  supports this claim.

7
The Three Forms of Efficiency
Semi-Strong Form Efficient
Strong Form Efficient
Weak Form Efficient
8
Points about Efficiency

• The idea of efficiency is that prices will be
  fair.
• All investments in securities will be zero NPV.
• Intense competition prevents a free lunch.
• Think of efficiency as a matter of degree.
• Just like some cars are more fuel efficient than
  others, some markets are more informationally
  efficient.
• Efficiency may change over time or market
  conditions. The availability of computers has
  increased our ability to collect, distribute, and
  process information quickly.

9
Points about Efficiency

• To be precise, efficiency says there is no way to
  profit from available information after
  considering information processing and
  acquisition costs.
• Efficiency does not mean that investments
  decisions can be made mindlessly.

10
What you should know?

• How are different forms of market efficiency
  defined? Make sure you know how to detect them,
  when given a case