Market Efficiency

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Market Efficiency

• Definition
• Market efficiency means all stocks fully reflect
  all current information
• In an informationally efficient market the
  expected return for securities is on average
  equal to the required rate of return

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Efficient Capital Markets

• Necessary conditions for an efficient market
• 1. Large number of profit maximizing
  participants valuing securities independently
• 2. New information comes to the market in a
  random fashion
• 3. Market reacts to information rapidly
• 4. Expected returns implicitly include the risk
  of a security

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Market Efficiency

• Mathematical representation of market efficiency
• Xj,t1 pj,t1 E(pj,t1 It)
• Xj,t1 Abnormal profit to be made after
  considering all information
• Market efficiency says that E(Xj,t1It) 0.
  Thus, on average no profits can be made by
  trading on a particular information set.

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Market Efficiency

• Different Levels of Information
• Market participants have different information
  sets
• 1. Weak form efficiency
• Prices reflect historical all security market
  information
• 2. Semistrong-form efficiency
• Prices contain all public information
• 3. Strong-form efficiency
• Prices contain all information

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Testing market efficiency

• Rational vs. irrational inefficiencies
• Rational inefficiency exists due to transactions
  costs or other trading barriers
• Irrational inefficiency is an inefficiency on
  which we can make money
• An inefficiency can be rational if the
  inefficiency is consistent with changes in
  expected returns

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Testing market efficiency

• Calculation of abnormal returns
• A securities abnormal return is defined as the
  actual return minus what is expected.
• ARit Rit E(Rit) for security i on day t
• There are many ways to measure E(Rit) including
  the simple market return, an average return or a
  risk adjusted return.
• The results of efficiency tests are sensitive to
  how expected returns are defined.

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Tests of weak form efficiency

• 1. Statistical tests of independence
• Autocorrelation tests
• Tests the significance of correlations across
  time
• Autocorrelation should not be significantly
  different from 0 if markets are weak form
  efficient
• Evidence from these tests shows positive first
  order autocorrelations in both daily and weekly
  returns

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Tests of weak form efficiency

• 1. Statistical tests of independence
• Run tests
• If security returns are independent, there should
  only be a certain number of positive or negative
  return runs with in a series of returns
• Runs tests generally support the weak form
  hypothesis

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Tests of weak form efficiency

• 2. Trading rule tests
• Advocates of technical analysis argue that the
  above statistical tests do not account for more
  complex patterns in security returns
• Trading rule tests rely on simulation to test if
  certain rules can be used to make abnormal
  profits
• Trading rule tests compare returns to some
  trading rule to a simple buy and hold strategy

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Tests of weak form efficiency

• 2. Trading rule tests
• Trading rule tests must account for
• transaction costs
• availability of data
• risk
• Filter rules are the most common form of trading
  rule test
• Generally, results of trading rule tests support
  the weak form hypothesis where trading rules do
  not beat buy-and-hold strategies

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Tests of weak form efficiency

• 3. Cross-autocorrelations in returns
• Tests whether certain groups of securities lead
  other groups of securities
• Results find significant cross-autocorrelations
  in returns
• Many studies attribute cross-autocorrelations to
  differential information between market
  participants

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Tests of weak form efficiency

• 4. Calendar anomalies
• January effect
• Weekend effect

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Tests of semistrong form efficiency

• Tests of the predictability of security returns
• 1. Macro-economic factors and security returns
• Default spread (Corporate bond yield Govt bond
  yield)
• Term spread (long term yield short term yield)
• The evidence is mixed but generally the
  significance (if any) of these variables is
  explained in a context consistent with market
  efficiency

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Tests of semistrong form efficiency

• 1. Tests of the predictability of security
  returns
• Earnings surprises
• Post earnings announcement drift
• Firm-specific variables
• Size
• Dividend-yield
• P/E ratio
• BV/MV ratio
• Analyst following

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Tests of semistrong form efficiency

• 2. Event studies
• Event studies are used to test the markets
  reaction to information announcements
• These tests are tests of semistrong form market
  efficiency because if markets are SS form
  efficient new information should be impounded
  very quickly into stock prices.
• If markets are SS efficient we would expect there
  to be an abnormal return on day zero only in
  response to the new information

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Tests of semistrong form efficiency

• 2. Event studies
• The vast majority of these studies fin markets
  adjusts rapidly to new information
• Mergers
• Some evidence of insider trading before
  announcement
• Security issues
• IPOs
• Seasoned equity offerings

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Tests of strong form efficiency

• 1. Corporate insider studies
• Insiders earn abnormal returns
• 2. Security analysts performance studies
• Value Line
• Firms ranked 1 or 2 by value line and those
  changing rankings have abnormal returns
• Professional money managers
• Mutual funds and pension funds do not beat the
  market after considering the costs of management
• Less than half of the funds outperform the market
  and the performance is not persistent (we cant
  pick the winners)

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Implications of efficient markets

• 1. Technical analysis
• If markets are efficient in the weak form then
  technical analysis cannot generate abnormal
  returns
• 2. Fundamental analysis
• Fundamental analysis focuses on estimating the
  intrinsic value of a security or market.
• A superior analyst must determine what affects
  security value better than the market.

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Implications of efficient markets

• 3. Investors with better information than the
  rest of the market will earn abnormal returns
• 4. Even if markets are completely efficient,
  some investors will beat the market