The Efficient Market Hypothesis

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• Part 8
• The Efficient Market Hypothesis
• Topics Covered
• How Information Affects Share Price?
• Efficient Market Hypothesis (EMH)
• Implications of EMH

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8.1 Information that will affect a stock price

• Imagine an event that will affect a stock price
• A mining firm strikes a rich vein of ore
• A drug company receives approval for a new drug
• A firm (such as Goldman Sachs today) reports
  unexpectedly higher profits
• An unpopular CEO resigns unexpectedly
• A firm announces a stock buy-back program,
  etc., etc.
• Information that will affect a stock price is
  called material information.

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8.2 Speed of the stock price reaction

• Does the stock price change slowly or does it
  change immediately?
• Does the information get to some market
  participants before others?
• Questions about how fast important information
  becomes incorporated in stock prices (or any
  financial asset prices) are questions about the
  informational efficiency of the stock market

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8.3 Definition of an Efficient Market

• A market is said to be (informationally)
  efficient if the price response to new
  information is prompt and unbiased.
• It is impossible to earn profits systematically
  based on available information in an efficient
  market.
• Due to the arrival and magnitude of the new
  information about the firms cash flows or
  interest rates are unpredictable, prices are
  random.

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8.4 Efficient Market Prices Follow a Random
Walk

• Empirical Observation
• If the stock price fell yesterday, is it going up
  or down today?
• If the stock price dropped in the last three
  months, will it continue to drop this month?
• If stock prices are not random and they are
  predictable, then someone who has such an ability
  to predict stock prices can make an infinitely
  large amount of money.

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8.5 Random Prices and Hot Hands

• Even if market prices are random, there are still
  some lucky winners, or hot hands.
• Even if the market price is random, some lucky
  investors can beat the market for many
  consecutive years.
• It is hard to distinguish skills from good luck.

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8.6 Three Forms of Efficiency Weak Form

• Weak Form Prices reflect all historical
  information contained in the record of past
  prices and volumes.
• Are the chartists techniques profitable?
• The technical analysts (also called chartists)
  make prediction of future share prices based on
  historical pattern of prices (to a lesser degree,
  trading volumes as well).

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8.7 Semi-Strong Form Efficiency

• Semi-strong Form Prices reflect all publicly
  available information.
• Does it pay to hire fundamental analysts to do
  fundamental analysis?
• Fundamental analysts are those working for
  investment banks or managed funds who do detailed
  research based on the DCF analysis to decide
  whether to buy or sale.

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8.8 Strong Form Efficiency

• Strong Form Prices reflect all public and
  private information.
• Is insider trading profitable?
• Insiders refer to those corporate directors,
  managers, consultants, and large investors who
  possess non-public information.
• The empirical evidence, in general, (but not
  without exceptions), show that the stock market
  is weak-form and semi-strong form efficient, but
  not strong-form efficient.

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8.9 Implications of EMH

• Markets have no memory
• One can trust markets better than anything else
• No financial Illusions
• Example issuing stock only when the market has
  risen (or repurchasing only when the market has
  fallen) is a form of market timing. Market
  reaction to the announcement of equity issues 3
  drop on average for industrial issues.
• Earnings management/creative accounting may be
  pointless.

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8.10 A Practical Definition

• We might define an efficient market as one in
  which price is within a factor of 2 of value,
  i.e., the price is more than half of value and
  less than twice value. The factor of 2 is
  arbitrary, of course. Intuitively, though, it
  seems reasonable to me, in the light of sources
  of uncertainty about value and the strength of
  the forces tending to cause price to return to
  value. By this definition, I think almost all
  markets are efficient almost all of the time.
  Almost all means at least 90 percent.
• Fischer Black, 1986 Presidential Address to the
  American Finance Association

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8.11 An Important Message

• Diversification offers many advantages in a
  highly competitive environment, it is very
  difficult to obtain information not already
  reflected in market prices consequently, one
  should be very cautious about giving up
  diversification in an attempt to use special
  information, especially when significant
  transactions costs will be incurred as well.
• ---------- Professors Cox
  Rubinstein
• Options Markets