Efficient market hypothesis
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The document discusses the efficient market hypothesis which states that financial markets are efficient and security prices reflect all available information. It provides evidence that markets are at least semi-strong form efficient in that publicly available information does not allow consistently beating the market. The hypothesis implies that no investments are better than others and security prices accurately reflect risk and return. While markets quickly react to new information, predicting short-term movements is very difficult. Overall, the evidence supports some level of market efficiency.
Efficient market hypothesis
- 1. Efficiency of Financial Markets Are Financial Markets Efficient?
- 2. • Expectations are very important in our financial systems – Expectations of risk, returns and liquidity impact asset demand – Inflationary expectations impact bond prices – Expectations not only affect our understanding of markets, but also how financial institutions operate Efficiency of Financial Markets
- 3. • To better understand expectations, we examine the efficient markets hypothesis. – Framework of understanding what information is useful and what is not – However we need to validate the hypothesis with market real data. The results are mixed, but generally supportive of the idea Efficiency of Financial Markets
- 4. Efficient Market Hypothesis • You may recall from that the rate of return from holding a security equals the sum of the capital gain on the security (the change in the price) plus any cash payments, divided by the initial purchase price of the security: where R = rate of return on the security held from time t to time t + 1 (say, the end of 2011 to the end of 2012) Pt+ 1 = price of the security at time t + 1, the end of the holding period Pt = the price of the security at time t, the beginning of the holding period C = cash payment (coupon or dividend payments) made in the period t to t + 1 R= Pt+1-Pt+C Pt
- 5. • Let’s look at the expectation of this return at time t, the beginning of the holding period. Because the current price and the cash payment C are known at the beginning, the only variable in the definition of the return that is uncertain is the price next period, Pt+ 1. Denoting the expectation of the security’s price at the end of the holding period as, the expected return Re is Re= Pt+1 e - P t+ C Pt
- 6. • The efficient market hypothesis views expectations as equal to optimal forecasts using all available information. • An optimal forecast is the best guess of the future using all available information. This does not mean that the forecast is perfectly accurate, but only that it is the best possible given the available information. This can be written more formally as Pt+1 e =Pt+1 of which in turn implies that the expected return on the security will equal the optimal forecast of the return: Re =Rof
- 7. • Unfortunately, we cannot observe either Re or , so the equations above by themselves do not tell us much about how the financial market behaves. However, if we can devise some way to measure the value of Re, these equations will have important implications for how prices of securities change in financial markets. ,
- 8. • The supply-and-demand analysis of the bond market shows us that the expected return on a security (the interest rate in the case of the bond examined) will have a tendency to head toward the equilibrium return that equates the quantity demanded to the quantity supplied. Supply-and-demand analysis enables us to determine the expected return on a security with the following equilibrium condition: The expected return on a security • Re equals the equilibrium return R*, which equates the quantity of the security demanded to the quantity supplied; that is Re = R*
- 9. • The academic field of finance explores the factors (risk and liquidity, for example) that influence the equilibrium returns on securities. For our purposes, it is sufficient to know that we can determine the equilibrium return and thus determine the expected return with the equilibrium condition. We can derive an equation to describe pricing behavior in an efficient market by using the equilibrium condition to replace Re with R* in above equation. In this way we obtain Rof = R* This equation tells us that current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. Financial economists state it more simply: A security’s price fully reflects all available information in an efficient market.
- 10. Re= Pt+1 e - P t+ C Pt R= Pt+1-Pt+C Pt Expectations equals to optimal forecast implies Pt+1 e =Pt+1 of Re =Rof Market Equilibrium Re = R* Efficient Market Hypothesis Rof = R*
- 11. Why efficient market hypothesis makes sense IfRof >R* Pt Rof If Rof < R* Pt Rof Until Rof = R* All unexploited profit opportunity eliminated Efficient market of condition holds even if there are un- uniformed, irrational participants in market
- 12. • When an unexploited profit opportunity arises on a security ( so-called because, on average, people would be earning more than they should, given the characteristics of the security) investors will rush to buy until the price rises to the point that the returns are normal again. • In an efficient market, all unexploited profit opportunities will be eliminated • Not every investor need be aware of every security and situation, as long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunity that appear because in so doing , they make profit.
- 13. Stronger Version of the Efficient Market Hypothesis • Many financial economists take the efficient market hypothesis one step further in their analysis of financial markets. Not only do they define an efficient market as one in which expectations are optimal forecasts using all available information, but they also add the condition that an efficient market is one in which prices reflect the true fundamental (intrinsic) value of the securities. • Thus, in an efficient market, all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities).
- 14. This stronger view of market efficiency has several important implications in the academic field of finance. 1. it implies that in an efficient capital market, one investment is as good as any other because the securities’ prices are correct. 2. it implies that a security’s price reflects all available information about the intrinsic value of the security. 3. it implies that security prices can be used by managers of both financial and nonfinancial firms to assess their cost of capital (cost of financing their investments) accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making or not. Stronger Version of the Efficient Market Hypothesis
- 15. Evidence on the Efficient Market Hypothesis • Evidence in Favour of Market Efficiency -Investment analyst and mutual funds don’t beat the market -Stock prices reflect publically available information: anticipated announcements don’t affect stock price -Stock price and exchange rates close to random walk; if predictions of big, Rof >Re predictions of small. -Technical analysis does not outperform market. P P
- 16. Forms of Market Efficiency, (i.e., what information is used?) • A Weak-form Efficient Market is one in which past prices and volume figures are of no use in beating the market. – If so, then technical analysis is of little use. • A Semistrong-form Efficient Market is one in which publicly available information is of no use in beating the market. – If so, then fundamental analysis is of little use. • A Strong-form Efficient Market is one in which information of any kind, public or private, is of no use in beating the market. – If so, then “inside information” is of little use.
- 17. Information Sets for Market Efficiency
- 18. Why Would a Market be Efficient? • The driving force toward market efficiency is simply competition and the profit motive. • Even a relatively small performance enhancement can be worth a tremendous amount of money (when multiplied by the amount involved). • This creates incentives to unearth relevant information and use it.
- 19. Are Financial Markets Efficient, I? • Financial markets are the most extensively documented of all human endeavors. • Colossal (huge) amounts of financial market data are collected and reported every day. • These data, particularly stock market data, have been exhaustively analyzed to test market efficiency. • But, market efficiency is difficult to test for these reasons: – The risk-adjustment problem – The relevant information problem – The data snooping problem
- 20. Are Financial Markets Efficient, II? Nevertheless, three generalities about market efficiency can be made: – Short-term stock price and market movements appear to be difficult to predict with any accuracy. – The market reacts quickly and sharply to new information, and various studies find little or no evidence that such reactions can be profitably exploited. – If the stock market can be beaten, the way to do so is not obvious.
- 21. Some Implications if Markets are Efficient • Security selection becomes less important, because securities will be fairly priced. • There will be a small role for professional money managers. • It makes little sense to time the market.