Basic Finance

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5. Market Efficiency
Basic Finance – Market Efficiency
*Market Efficiency = Informational Efficiency (common language)
5.1. Market Efficiency Concept
1. Informational Efficiency - market capacity to generate prices that
instantly reflect all available relevant information
2. Allocative Efficiency - market capacity to allocate the capital
starting from the most profitable to the less profitable investment
projects
3. Operational Efficiency - market capacity to minimize the cost of
capital rising (transaction costs)

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Basic Finance – Market Efficiency
Informational Efficiency - assertion of EMH (efficient-market
hypothesis)
References:
*Bachelier, Louis; Mark Davis, Alison Etheridge - Louis Bachelier’s
Theory of Speculation: The Origins of Modern Finance, Princeton
University Press , 2006, pp. 116-182.
*Fama, Eugene – “Efficient Capital Market: A Review of Theory
and Empirical Work”, Journal of Finance, 25 May 1970, pp. 34-105.
*Dragota, Victor; Mitrica, Eugen,. Emergent capital markets'
efficiency: The case of Romania, European Journal of Operational
Research, Elsevier, vol. 155(2), June 2004, pp. 353-360.

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Basic Finance – Market Efficiency
EMH theory: prices of securities traded already reflect all known
information
Impossibility to consistently (overperform the market*) by using
any known information
(*)Investor return > market index return

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Basic Finance – Market Efficiency
Main features of the informational efficient market:
1. Unpredictable return - market operators
(investors/hedgers/speculators) are unable to predict the future
periods of abnormal return, positive and /or negative, neither to
predict the securities that will have such abnormal returns.
- abnormal return = any significant difference between current and
expected return
- expected return = return resulted from any valuation model (return
of “buy and hold” investment strategy)

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Basic Finance – Market Efficiency
2. Funds are allocated to similar risky investments based on the rule of
profit maximization => proportional risk premiums for securities
specific (unsystematic) risk
3. No investors can reach abnormal systematic earnings
(return of managers of investment funds = market return <=>
no systematic abnormal (excess) return over the market return or over
the return of a “buy and hold” investment strategy)
=>
real expected return for securities = equilibrium expected return

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Basic Finance – Market Efficiency
5.2. Levels of Informational Efficiency
Three levels of information (from the less to the most inclusive) (Fama (1970)):
- historical information
- public information, including historical information
- public and private information
1. Historical information - past price movement (implicitly reflects the
securities’ history)
2. Public information - all publicly available information (including historical
information) Examples: issuing company’s financial statements; budgets;
announcements (mergers/joint ventures/liquidations); information about the
macroeconomic environment; etc
3. Private information - privileged information, usually only available for
companies’ insiders (directors; middle management; other personnel)

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Basic Finance – Market Efficiency
Three forms of informational efficiency:
I. Weak form - current prices of securities fully and instantly reflect all
security’s past price history
=>
impossibility to make consistent and/or systematic excess gains by
trading securities based on the study of their price movement history
There is no theoretical basis for the technical analysis / chartist
theory - forecasting of market prices by the means of analysis of data
generated by the process of trading
*Although, in case of market crises weak efficient market can react
inefficient => technical analysis becomes useful

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Basic Finance – Market Efficiency
II. Semi-strong form - current prices of securities fully and instantly
reflect all publicly available information
=>
impossibility to make consistent and/or systematic excess gains by
trading securities based on any new publicly available information
(including price history)
* Fundamental analysis (method of security valuation which involves
examining the company's financials and operations, especially sales,
earnings, growth potential, assets, debt, management, products and
competition) is useless

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Basic Finance – Market Efficiency
III. Strong form (theoretical existence) - prices of securities fully and
instantly reflect all information, public and private
=>
impossibility to make to make consistent excess gains by trading
securities based on any information, public and private (privileged
inside information)
*Insiders and their related parties (relatives) are unable to make
excess gains (unrealistic but partly implemented by capital market
rules) - insiders and their first grade relatives are prohibited to trade
securities based on privileged information - any excess gain made by
the insiders or their first grade relatives is deeply investigated by
capital market authorities

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Basic Finance – Market Efficiency
5.3. Formal model of informational efficiency
- “Fair game” model: nobody is able to make excess gain
-“Random walk” (RW): the best forecasts of the next period securities prices =
current prices
Rk,t+1 = E(Rk,t+1|It) + εi,t+1 = Rk,t + εk,t+1;
Rk,t+1 = the actual return on security k in period t+1 (neglecting the dividend yield)
E(Rk,t+1|It) = the expected return on security k in period t+1, given the available information at
time t (It);
εk,t+1 = the forecast error, that is the difference between the actual return in the next period
(t+1) and the expected return at time t
Randomness of errors comes from their properties:
 average of errors = 0 (positive and negative errors compensate each other)
 errors should not be autocorrelated (current error of forecasting the return should not be
correlated with the prior errors)
 error should be also independent of security return (error and return variables should
be uncorrelated)

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Basic Finance – Market Efficiency
New scientific approaches:
-fractal theory (explains the price evolution splitting it in similar movement periods)
-neural network theory (the market prices evolve like self-learning systems)
7.4. Testing the informational efficiency
 Weak informational efficient market => technical analysis is for the most time
useless
 Semi-strong informational efficient market => fundamental analysis is for the
most time useless
*Most theoretical models assume the efficiency of financial market (at least in its weak form)

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Basic Finance – Market Efficiency
 Testing weak informational efficiency
(evaluate whether it is possible to make excess profits over the normal profits associated to
securities systematic risks)
A. Correlation between current and past returns (autocorrelation)
B. Filter rules
A1. Chart study (chart of points cloud) - points (Rk t; Rk t+1) are drawn in the chart
with the origin in the average of the return series (Example: Daily Return autocorrelation
for ATBE security, traded at the BSE (1998-2000) Source: Victor Dragotă; Eugen Mitrică –
„Romanian Capital Market – Testing Efficiency“ www.science.mii.lt/EWGFM-28/straip.htm)

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Basic Finance – Market Efficiency
A2. Statistical tests
- autocorrelation coefficient (current and future daily return)
ρ(Rt,Rt+1) є [-1; 1]
- complex statistical tests (random walk price movement): Augmented
Dickey – Fuller test (ADF); Phillips-Perron test (P-P)
B. Filter rules (empirical test)
*This test simulates trading based on price history and a trading rule that
stipulates selling or buying in case of price variation over a limit, selected
by the investor. This limit is usually a certain percent (± α %), considered
significant for a tendency reverse. If such a simulated trading strategy
generates significant excess return over the return of a buy and hold
investment strategy, after deduction of the brokerage fees, this is a sign of
market’s informational inefficiency

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Basic Finance – Market Efficiency
Testing semi-strong informational efficiency (events studies)
- study of the market evolution before and after an event that
generates public information related to a security (mergers,
acquisitions, any splitting, releases of financial statements and any
other company announcements)
- the tests evaluate if the securities prices behave like a speculative
bubble before and after an event (sign of semi-strong informational
inefficiency)
* chart study – only indicative
**developed statistical tests designed to quantify the abnormal
returns, compared with returns resulted from different pricing models
(for example, CAPM)

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Basic Finance – Market Efficiency
Testing the strong informational efficiency (empirical performance
tests)
-study of (abnormal) returns made by investment / mutual fund by
trading in the capital market compared with different benchmarks –
returns resulted under different pricing models
-lack of significant abnormal returns => strong informational
efficiency
* Developed markets are not strongly informational efficient
** In case of crisis even other forms of informational efficiency are
unfulfilled
***“January effect” and “Week-end effect” - temporarily lack of the
weak efficiency