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.

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.