The Efficient Capital Markets

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The Efficient Capital Markets

• By Ding zhaoyong

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Main Contents

• The concept of efficient capital markets
• Alternative efficient market hypotheses
• The tests and results of EMHs
• The implication of EMHs

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Efficient Capital Markets

• Efficient capital market is one in which security
  prices adjust rapidly to the arrival of new
  information and, therefore, the current prices of
  securities reflect all information about the
  security.
• Efficient Market Hypotheses (EMH ) are those
  alternative hypotheses which consider the
  efficiency of the markets

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Efficient Capital Markets

• An efficient capital market imply
• A large number of competing profit-maximizing
  participants analyze and value securities, each
  independently of the others.
• New information regarding securities comes to the
  market in a random fashion, and the timing of one
  announcement is independent of others

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Efficient Capital Markets

• The competing investors attempt to adjust
  security prices rapidly to reflect the effect of
  new information, although imperfect and unbiased.
• The security prices that prevail at any times
  should be an unbiased reflection of all currently
  available information. The expected returns
  implicit in the current price should reflect its
  risk.

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Efficient Capital Markets

• Random walk hypothesis
• the notion that stock prices changes are random
  and unpredictable.
• Dealing with price movement over time
• Efficient market hypothesis
• the notion that stock prices already fully
  reflect all available information.
• The fair game model( specified time)

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Efficient Capital Markets

• Investors will have an incentive to spend time
  and resources to analyze and uncover new
  information only if such activity is likely to
  generate high returns
• Competition among many well-backed, highly paid,
  aggressive analysts ensure stock prices ought to
  reflect available information regarding their
  proper levels

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Alternative EMHs

• The weak-form EMH assumes that stock prices fully
  reflect all security-market information.
• Including the historical of price, rates of
  return, trading volume data, and other
  market-generated information, such as block
  trades, short interest, odd-lot transactions.

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Alternative EMHs

• The semistrong-form EMH asserts that security
  prices adjust rapidly to the release of all
  public information.
• Public information includes all market and
  non-market information, such as earnings and
  dividend announcement, P/E ratios, D/P ratios,
  BV/MV ratios, product line, patent held, economic
  news, political news, etc.

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Alternative EMHs

• The strong-form EMH contends that stock prices
  reflect all information from public and private
  sources relevant to the firm, including
  information available only to company insider.
• It extends the assumption of efficient markets to
  assume perfect markets in which all information
  is cost-free and available to everyone at the
  same time.

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Tests of the EMHs

• The difficulties of EMH tests
• The magnitude issueonly managers of large
  portfolios can earn enough trading profits to
  make the exploitation of minor mispricing worth
  the effort.
• The selection bias issue we can not fairly
  evaluate the true ability of portfolio managers
  to generate winning stock market strategies.

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Tests of the EMHs

• The lucky event issue any bet on a stock is
  simply a coin toss. If many investors using a
  variety of schemes make fair bets, statistically
  speaking, some of those investors will be lucky
  and win a great majority of bets.

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Test of Weak-Form EMH

• Returns over short horizon
• test of the efficiency of technical analysis
• runs analysis of stock price
• serial correlation in stock returns
• filter rule analysis
• Returns over long horizon
• long-term serial correlation

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Test of Semisrtong-Form EHM

• D/P ratios analysis
• P/E effect
• The small-firm effect
• The January effect
• The neglected-firm and liquidity effect
• Market-to-book ratios
• Reversal effect
• The day-of-week effect

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Test of Strong-Form EHM

• Inside information
• The value line enigma
• The market crash
• Mutual fund performance
• performance across section
• performance across time

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Implications of the EMHs

• The EMH and Technical Analysis (TA)
• TA is the search for recurring and predictable
  patterns in stock prices
• The assumption of gradually response of stock
  prices to events is opposed to the notion of an
  efficient market
• One should not expect abnormal returns through TA
  if EMH is true.

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Implications of the EMHs

• The EMH Fundamental Analysis(FA)
• The EMH predicts that most FA adds little value.
• One can make money only if his analysis is better
  than that of his competitors because the market
  price is expected already to reflect all commonly
  available information.

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Implications of the EMHs

• The EMH Portfolio Management(PM)
• Only serious, time-consuming, and expensive
  technique are likely to generate the differential
  insight necessary to generate trading profit.
• Active PM is largely wasted effort
• Passive PM and Index fund

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Implications of the EMHs

• The EMH and the role of PM
• Portfolio selection diversification v.s.
  Firm-specific risk
• Tax consideration for specific client
• Particular risk profile of the investor
• Other factors age, employment
• Tailor the portfolio to above needs, rather than
  to attempt to beat the market.