ECF5220 Principles of Finance – Note 12

18/10/2011

Objectives
Successful completion of this week’s work should enable you to:
Identify the information levels of the Efficient Market Hypothesis (EMH) Describe the methods used to test the different levels of the EMH Assess the implications of the EMH for investors and financial managers Discuss the reasons for the development of behavioural finance Understand the relative merits of the traditional and behavioural arguments
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Efficient Market Hypothesis (EMH)
Identify the information levels of the EMH Understand the methods used to test the EMH Assess empirical studies of the EMH Assess implications for investors and companies
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Types of Efficiency
Operational efficiency
Refers to the cost, speed and reliability of transactions in securities on the exchange

Allocational efficiency
Allocating scarce resources to where they can be most productive

Pricing efficiency
Efficient market hypothesis – prices move instantaneously and unbiasedly to any news
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Efficient Market Hypothesis (EMH)
Fama (1970) – Share prices will reflect any change in firm’s values due to new information Prices are set by agents who:
Can interpret the information available Have sensible preferences

3 Forms of the EMH
Versions of the EMH differ by the type of information reflected in prices Weak form efficiency y
Information on past prices

Semi‐strong form efficiency
All publicly available information

Not possible to earn abnormal returns from analysis of the available information –
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Strong for efficiency
All information (private and public)
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ECF5220 Principles of Finance – Note 12

18/10/2011

Weak Form Efficiency
Information contained in the past sequence of prices is fully reflected in the current market price Nothing to be gained by looking back Trading strategies based on patterns and trends of past prices will not

Tests for Weak Form Efficiency
Tests for patterns or correlation between returns Tests of trading strategies on past data Results suggest stock market is weak‐form efficient (almost zero correlations in intra‐ day, daily and weekly stock prices) And is getting more efficient as information is moving, and being priced, faster
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Semi‐Strong Form Efficiency
Prices reflect all past price and public information To test study specific events y p
Event Studies

Tests for Semi‐Strong Form Efficiency
Mixed findings Majority of early evidence (1960s and 1970s) support the hypothesis ) t th h th i Some anomalies in the market may be caused by A tendency to anticipate good news and to underestimate response not instantaneous
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Is there instantaneous and unbiased reaction to a public announcement?
e.g.

Strong Form Efficiency
Prices reflect all past price, public and private information How do you test for private information?
Can directors make abnormal returns? Can managed funds make abnormal returns?

Tests for Strong Form Efficiency
Directors do tend to Evidence suggests managed funds perform less well than might be expected
Under perform the market half the time

Very hard to test Results to date suggest market is not strong form efficient If insider trading laws are effective private information will
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ECF5220 Principles of Finance – Note 12

18/10/2011

Conclusions on the EMH
Weak form efficiency – Semi‐strong form efficiency –
Evidence is significant but not so overwhelming Hope of outperformance for the able and dedicated

Possible Explanations for Inefficiency
Data problems Is data accurate? Problems with asset pricing models p g Does benchmark model hold? Problems with investors Problems with markets Maybe they are
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Strong form efficiency ‐

Implications of EMH for Investors
Value of Charting Value of Fundamentals Active investment depends on inefficiency/ But inefficiencies are likely to be Can the investor do better than buy‐