The document discusses the Efficient Market Hypothesis (EMH). Some key points:
- EMH proposes that market prices fully reflect all available information and investors cannot consistently earn abnormal returns. It originated from the Random Walk Hypothesis.
- There are three forms of EMH (weak, semi-strong, strong) based on the information reflected in prices. Research initially supported weak and semi-strong forms but questioned strong form.
- Over time research identified anomalies like momentum and mean reversion that appear to allow abnormal returns, bringing EMH into question. Behavioral finance emerged examining psychological factors.
- While still debated, EMH is no longer considered the sole determinant of market behavior.
According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
Abstract
The idea of an Efficient Market first came from the French mathematician Louis Bachelier in 1900: « The theory of speculation ».
Bachelier argued that there is no useful information in past stock prices that can help predicting future prices and proposed a theory for financial options’ valuation based on Fourier’s law and Brownian’s motions (time series).
Bachelier’s work get popular in the 60s during the computer’s era.
In 1965, Eugene Fama published a dissertation arguing for the random walk hypothesis (Stock market’s prices evolve randomly: prices cannot be predicted using past data).
In 1970, Fama published a review of the theory and empirical evidences
The EMH (Efficient Market Hypothesis): Financial markets are efficient at processing information. Consequently, the prices of securities is a correct representation of all information available at any time.
Weak:
Not possible to earn superior profits (risk adjusted) based on the knowledge of past prices and returns.
Semi-strong:
Not possible to earn superior profits using all information publicly available.
Strong:
Not possible to earn superior profit using all publicly and inside information.
The CAPM describes the relationship between market risks and expected return for a security i (also called cost of equity), E(Re_i):
Re_i = Rf – Bi(Rm – Rf)
With:
Rf = Risk free rate (typically government bond rate)
Rm = Expected return for the whole market
Bi = The volatility risk of the security i compared to the whole market
(Rm – Rf) is consequently the market risk premium
According to the EMH, for a well-diversified portfolio, expected returns can only reflect those of the market as a whole. Consequently, in the CAPM formula, It would involves that for a diversified-enough portfolio: β = 1 so Re = Rm
Investors want to value companies before making investment decisions.
A typical way to do so is to use the Discounted Cash Flow (DCF) method:
See also: Prospect theory, disposition effect, heuristic, framing, mental accounting, Home bias, representativeness, conservatism, availability, greater fool theory, self attribution theory, anchoring, ambiguity aversion, winner's curse, managerial miscalibration and misconception, Equity premium puzzle, market anomalies, excess volatility, Bubbles, herding, limited liabilities, Fama French three 3 factors model.
: Security and Portfolio Analysis :Efficient market theoryRahulKaushik108
Key Concepts of Efficient market theory: Very Lucid presentation , very Useful for MBA student to understand the Concepts of Efficient Market theory( Random walk hypotheses ) .The key idea of the hypotheses is" no one can efficiently out predict the market" or in other terms, technical analysis or fundamental analysis can not beat "the naive buy and hold strategy".
noorulhadi Lecturer at Govt College of Management Sciences, noorulhadi99@yahoo.com
i have prepared these slides and still using in mylectures, Reference: Portfolio management by S kevin and onlin
Abstract
The idea of an Efficient Market first came from the French mathematician Louis Bachelier in 1900: « The theory of speculation ».
Bachelier argued that there is no useful information in past stock prices that can help predicting future prices and proposed a theory for financial options’ valuation based on Fourier’s law and Brownian’s motions (time series).
Bachelier’s work get popular in the 60s during the computer’s era.
In 1965, Eugene Fama published a dissertation arguing for the random walk hypothesis (Stock market’s prices evolve randomly: prices cannot be predicted using past data).
In 1970, Fama published a review of the theory and empirical evidences
The EMH (Efficient Market Hypothesis): Financial markets are efficient at processing information. Consequently, the prices of securities is a correct representation of all information available at any time.
Weak:
Not possible to earn superior profits (risk adjusted) based on the knowledge of past prices and returns.
Semi-strong:
Not possible to earn superior profits using all information publicly available.
Strong:
Not possible to earn superior profit using all publicly and inside information.
The CAPM describes the relationship between market risks and expected return for a security i (also called cost of equity), E(Re_i):
Re_i = Rf – Bi(Rm – Rf)
With:
Rf = Risk free rate (typically government bond rate)
Rm = Expected return for the whole market
Bi = The volatility risk of the security i compared to the whole market
(Rm – Rf) is consequently the market risk premium
According to the EMH, for a well-diversified portfolio, expected returns can only reflect those of the market as a whole. Consequently, in the CAPM formula, It would involves that for a diversified-enough portfolio: β = 1 so Re = Rm
Investors want to value companies before making investment decisions.
A typical way to do so is to use the Discounted Cash Flow (DCF) method:
See also: Prospect theory, disposition effect, heuristic, framing, mental accounting, Home bias, representativeness, conservatism, availability, greater fool theory, self attribution theory, anchoring, ambiguity aversion, winner's curse, managerial miscalibration and misconception, Equity premium puzzle, market anomalies, excess volatility, Bubbles, herding, limited liabilities, Fama French three 3 factors model.
: Security and Portfolio Analysis :Efficient market theoryRahulKaushik108
Key Concepts of Efficient market theory: Very Lucid presentation , very Useful for MBA student to understand the Concepts of Efficient Market theory( Random walk hypotheses ) .The key idea of the hypotheses is" no one can efficiently out predict the market" or in other terms, technical analysis or fundamental analysis can not beat "the naive buy and hold strategy".
noorulhadi Lecturer at Govt College of Management Sciences, noorulhadi99@yahoo.com
i have prepared these slides and still using in mylectures, Reference: Portfolio management by S kevin and onlin
Discuss the differences between weak form, semi-strong form and strong form capital market efficiency, and critically evaluate the significance of the efficient market hypothesis (EMH) for the financial manager, using examples or cases in real-life.
This paper outlines the basics of Modern Portfolio Theory, the Capital Asset Pricing Model, 'Technical Analysis' and the Efficient Market Hypothesis. Far from being obsolesced, the underlying concepts still exist today though digital disruptions du jour shroud them,
2. Efficient Market Hypothesis
• Derived from Random Walk Hypothesis
▫ With a few modifications
• The concept may first be traced to writings of Bachellier (1900)
• However, in modern finance, has been developed on the basis of research during
1953-1965
• As a theory, the concept can be traced to Paul A Samuleson (1965)
• Eugene Fama through his research papers in 1965 & 1970 established it as a
proper theory and came up with the nomenclature
▫ Though several interpretations and Fama himself diluted the concept to a large extent later on
• Became the central piece of finance during 1970-1980
• Research thereafter especially 1987 started to question the validity of EMH
• Emergence of Behavioral Finance
• Heavily bruised but not yet knocked out; the fight continues
▫ The shifting goal-posts strategy has helped it to be from knocked out and may rather save
it in one form or other
▫ The EMH of 1970 is however dead even in the writings of its proponent.
3. Concept of Efficiency
▫ When prices fully reflect all available information and information
is discounted immediately, market is said to be informationally
efficient.
▫ When security prices are determined in a way investible capital
resources are optimally allocated in favour of best return provider
(for a given level of risk), market is said to be allocationally
efficient;
4. Concept of Efficiency in EMH
• 1st proposition of FAMA (1965,1970)
▫ Informational Efficient
Which breeds
Allocational Efficiency
▫ Means money will go to the best return provider
▫ Later on diluted to
Informational Efficiency only
▫ Latest
There might be anomalies like Momentum, Mean-reversion,
etc. [Tactical Avoidance of Inefficient Word]
But not possible to earn superior return
5. Lets hear from Horse’s Mouth
• Fama (Jan. 1965: ‘The behaviour of stock-market prices’):
‘…an “efficient” market for securities, that is, a market where, given the available information,
actual prices at every point in time represent very good estimates of intrinsic values.’
[Intrinsic Implies Fundamental]
▫ Echoes Samuleson “When stock prices equal the present expected value of their payoffs (their
fundamental value given a discount factor) they are unpredictable.
• Fama (1970):
‘A market in which prices always “fully reflect” available information is called “efficient.”’
• Jensen (1978):
‘A market is efficient with respect to information set θt if it is impossible to make economic profits
by trading on the basis of information set θt’ [‘By economic profits, we mean the risk adjusted
returns net of all costs.’]
• Fama (1991):
‘I take the market efficiency hypothesis to be the simple statement that security prices fully reflect
all available information. A weaker and economically more sensible version of the efficiency
hypothesis says that prices reflect information to the point where the marginal benefits of acting on
information (the profits to be made) do not exceed marginal costs (Jensen (1978).’
• Fama (1998):
‘…market efficiency (the hypothesis that prices fully reflect available information)...’
‘…the simple market efficiency story; that is, the expected value of abnormal returns is zero, but
chance generates deviations from zero (anomalies) in both directions.’
6. Foundations of EMH
• There is an intrinsic value of financial assets
• The huge army of traders keep prices near that intrinsic value
• No Arbitrage Opportunity
▫ Sophisticated traders keep the value near to its intrinsic value
▫ Though chance of noise, dependence and bubbles
The sophisticated traders will move to take benefit and keep bubbles to burst
before they build up to a sizeable extent.
• Price change will be subject to flow of new information which was not earlier
anticipated
• Information shall be absorbed immediately
▫ If there is a lag (delay) in absorption, that will be random
Sometimes before the news, sometimes after the news
• Joint Hypothesis
▫ As information absorption and its efficiency can be determined only with
reference to equilibrium pricing
▫ A test of efficiency will always be a joint test of
Market Efficiency
Pricing Model [CAPM, APT etc]
▫ So one can never be sure which one to blame
7. Forms of EMH –Fama (1970)
[Taxonomy (Naming) suggested by Roberts(1967)
• Weak-Form [later on Dubbed as “Test for Return Predictability” – Fama 1991]
▫ the information set includes only the history of prices or returns themselves
▫ A capital market is said to satisfy weak-form efficiency if it fully incorporate the information in
past stock prices.
▫ If true, past prices alone would not be useful in making money. Technical analysis is of no use.
• Semi-Strong Form [later on Dubbed as “Event Studies”]
▫ the information set includes all information known to all market participants (publicly
available information).
▫ A market is semi-strong efficient if prices reflect all publicly available information.
▫ Past & Future expected performance, results, dividends etc are not useful in finding under-valued
stocks. Fundamental analysis is of no use
• Strong Form [later on Dubbed as “Test for private information”]
▫ the information set includes all information known to any market participant (private
information).
▫ This form says that anything that is pertinent to the value of the stock and that is known to at
least one investor is, in fact fully incorporated into the stock value.
▫ Even private information with insiders, market makers etc is of no use in generating excess
returns.
Taxonomy is relative and does not really shows something as weak or strong in absolute sense.
Momentum, a pure technical phenomenon, remains the biggest anomaly [Fama, 1997]
8. Implications of EMH
• Deviation from value is not ruled out,
however Equal chance that prices will
over-valued or under-valued
▫ For instance, stocks with lower PE ratios should
be no more or less likely to be under valued than
stocks with high PE ratios.
▫ As a result, no investor shall be consistently able
to find under-valued stock
•No investor or group of investors
should be able to consistently
outperform the market
9. Support for Efficient Walk Hypothesis
• Came in the form of various test results pre 1980
• The major tests in that era were in the form of
▫ Serial Correlation
▫ Run Tests
▫ Filter Test
Buy if price moves up by X% & sell if moves down by X%
Absurd level of simplification to reject technical analysis rules
▫ Event Studies
Impact on price of events such as stock split, earnings announcements etc.
It was found that market usually anticipated, absorbed and adjusted to the
information quickly
• As a result
▫ Weak Form was readily accepted; Semi-Strong form was accepted as well
▫ Strong form was not supposed to be possible
▫ EMH became THE GOD of modern finance for next 15-20 years
Such a powerful God that blasphemous papers (those criticizing EMH) were not
accepted by journals for publication [Until one of the big priests intervened]
10. Inherent Theoretical Flaws with EMH
• Assumes only news flow causes change in market price [Exogamous Markets]
▫ In Reality, Markets may change just in response to change in price
Bubbles are built up in such a fashion only
Market is an endogamous as well as exogamous entity
Theoretical support from French & Roll (1986) who found that return volatility is high for
days when markets are open for trading than on holidays; Dubbed noise by Black (1986)
1987 Crash when Portfolio Insurance (based upon EMH & CAPM) failed and the resulting
chaos caused 22% fall in a single trading session is an important example
The housing market bubble of 2001-2007 is just another example
• Assumes equilibrium but markets are in a constant dynamic environment [Bernstein 1999]
• From the above two, EMH concludes that prices are always right and hence determine
allocational efficiency
▫ If that is the case, how bubbles and their bursting is explained
• Not testable in itself and the pricing models can always be blamed
▫ As Fama & French did in 1992
• Ketch-Up Economics [Summers]
• If markets are efficient due to presence of large no. of rational investors
▫ And they can’t beat the market
Then they will stop looking for beating market and will thus market will become inefficient
Also, there is no incentive for anybody to do research as it’s a costly activity
[Grossman & Stiglitz 1980]
Fisher answered that Noise traders subsidize this cost
11. EMH- Negative Tests
• Test of Fundamental Value
▫ Variance Bound tests [Shiller 1981]
Price fluctuations in the long term are too large to be justified by variation in
dividend payments
It means that people over-react
Shiller rejected EMH altogether
▫ Equity Risk Premium Puzzle
The average risk premium in US between 1889-1978 was 7%
However, as per models of consumer behaviour; for average RFR of 0-4%, risk
premium shall not exceed by 0.35% [ Mehra & Presscot 1985]
• Anomalies
• Behavioral Criticism
12. Anomalies
• Anomaly means deviation from Norm
▫ So the results which are not in confirmation with EMH are dubbed as anomalies
▫ But what if EMH is an anomaly itself?
• With Specific reference to EMH, anomalies are defined as
▫ a regular pattern in an asset’s returns which is reliable, widely known, and
inexplicable [Andrew Lo, 2007]
• Some of the Anomalies are
▫ Size Effect
▫ Calendar & Seasonal Effect ---Like January Effect, Monday Effect etc.
▫ Momentum
▫ Mean Reversion
13. Momentum
• For price Movement in Months (3-12)
▫ Jagdeesh & Teetman [2001]
▫ Significant Positive correlation
What Goes Up-Goes Further Up (next 3-12 month)
What Goes Down – Goes Further Down
The phenomenon is known as Momentum
▫ Much more in vogue in US & European markets
▫ Lower in Emerging Markets
However, post 2003-2008 rally, it’s expected that momentum tests will
show positive correlation even in emerging markets now.
Due to significant inflow of money
• For price Movement in Weeks
▫ Andrew Lo [1997] A non-random walk down wall street
▫ Significant Positive correlation
• Momentum has been part of Technical Analysis Literature for long
Trend
Relative Strength
Moving Averages, MACD etc
14. Long-Term Correlation –
Mean Reversion
• For price Movement in Years (5 year returns)
▫ French & Fama [1988]
▫ Study Period [1945-1985]
▫ Significant Negative correlation (Reversion)
▫ Much More on 5 years basis than 1 year basis
▫ 25-40% change could be explained by past data [Andrew Lo]
19. Monday Effect - II
• Monday Effect – Some Nicities
▫ The Monday effect is really a weekend effect
▫ Bulk of the negative returns are manifested in the Friday close to Monday
open returns.
Stocks tend to open lower on Mondays
The returns from intraday returns on Monday (the price changes from open
to close on Monday) are not the culprits in creating the negative returns.
▫ The Monday effect is worse for small stocks than for larger stocks. This
mirrors findings on the January effect.
▫ The Monday effect is no worse following three-day weekends than two-day
weekends.
▫ Monday returns are more likely to be negative if the returns on the previous
Friday were negative.
In fact, Monday returns are, on average, positive following positive Friday
returns
Are negative 80% of the time following negative Friday returns.
21. Monday Effect IV
• Monday Effect – Holiday Contrast
▫ Can’t be ascribed to negative news over the weekend
22. Volume Behaviour
• Volume Patterns [Lee & Swaminathan 1998]
▫ For Momentum effect documented by Jagadeesh & Titman
More Pronounced for high volume stocks
Insistence of technicians
on High Volume Breakouts
proven
Winners do better with average
volume as extreme volumes
are usually sign of reversal
(In Technical Analysis)
23. Behavioral Finance
• Recognizes that there is no Homo Economicus [Rational Man]
• Brings psychological studies to the field of finance
• Some key Themes
▫ Heuristics:
People often make decisions based on approximate rules of thumb, not strict
logic
▫ Bounded Rationality
▫ Loss Aversion
▫ Heard Mentality
▫ Deviation from rationality
Over-reaction
Overconfidence
Optism
Extrapolation
Loss Aversion
Mental Accounting
24. Anomalies that can be explained by
Behavioural Finance
• Momentum
▫ Based upon heard mentality
• Mean-reversion
▫ When Over-reaction peters out
• Loss Aversion
▫ Holding onto Losers
• Bubbles
▫ Heard Mentality
25. Reality of Markets [Own Thoughts]
• Markets are dynamic entity, equilibrium in the long run is a foreign concept
▫ I.e., relationship between Risk & Return is unstable
Is guided by investor preferences and regulatory environment
Like the environment of Low Interest Rates in 2001-2007 may have fuelled the mortgage bubble.
• The relationship between Risk & Reward is not as quantitative as EMH assumes
▫ For Example, even a large no of so called intelligent analysts could not gauge the risk in
CDO Securities in the US
Risk in Sectoral Funds – In India
Risk in Zero Cost Options – In India
• Equity Risk premium is time and path dependent
• Arbitrage opportunities exist from time to time
▫ They disappear but only after long period of time : - Pair Trading, Bond Spreads, Value
Arbitrage
• Bubbles, Cycles, Trends, Crashes, Manias all are part of market
▫ Even with passage of time, they won’t be driven away as EMH assumed
• Investment activities will be able to generate super returns but not forever, innovation
is the key
▫ One needs to adapt to the change in market inefficiencies, behaviour, trading environment etc.
• But said that for most of the investors, it’s difficult to generate super-normal returns
▫ As it’s not easy to identify and also act upon profitable opportunities before they are too
common
26. EMH- Current Status
• Not the Singular God anymore
• Behavioural Finance especially post 2007-Crisis
is gaining momentum
• Still hotly debated
▫ Opinions have shifted more to No than Yes
▫ Even Greenspan has confessed to congress that
the market models he relied upon do not work
• Move towards assimilation
▫ With acceptance of low probability of
outperformance
27. Appendix I - Concept of Random (Stochastic) processes in
Financial Literature [Adopted/Modified from Probability Theory]
• Random Walk – As explained in RWH
▫ Independent Steps , i.e., successive changes are independent &
▫ Price changes confirm to an identical probability distribution
Normal Distribution was assumed in 1953-1965 [named Heterogeneous “RW” ≠ RW]
▫ Implies, random behaviour, no relationship with supply/demand and is like a casino, toss, dice,
etc.
If RW is correct, then price of green pea and price of IBM will move similarly
• Random Walk With Drift
▫ Independent Steps but bias to a particular direction
For example, in stock market prices don’t go below zero, That’s a positive drift.
• Martingale
For a given set of information:-
Pt+1 = Pt +at Such that Mean of at is zero over long run
That means best forecast of price tomorrow is today’s price if there is no change in information
Assumption is that that price changes on information concerning a security or market &
nothing else
• Fair game [aka Martingale Difference]
▫ Zero Expected Gain from forecasting tomorrow’s price based upon today’s information [For
Example 500 heads so far, Next can still be head or tail]
▫ That will mean Expected Return = Realized return [On probability basis in long term]
or Expected Return – Realized Return =0
Implies Price will move randomly around its intrinsic Value
28. Appendix II - From Random Walk to Martingale
• Random Walk [1900; 1953-1963]
▫ Variable and its moments (Mean, Variance, Skewness, Kurtosis, etc.) also shall be
random
▫ Further information flow and expectations about market shall also be random
▫ Kendell (1953) found that though wheat price/mean was random, its variance had
increased post WW I
That means it was a time-dependent function and not a random thing
Moved to heterogeneous RW, which is not RW in real sense of term
▫ The tests of RW, i.e., serial correlation & run tests were found to be deficient on
certain statistical parameters. Post 1980
▫ RW/HRW models were finally rejected.
• Martingale
Mandelbort (1963), Samuelson (1965); Assumes Risk Neutrality;
Variable and only its mean not higher moments are random.
• Fair game
▫ Fama (1965) came up with Fair Game model of EMH where deviation from
expected result is zero. He argued that Info. Flow and expectations may not be
purely random and that expected returns will not be stationery over time; hence
rejected random walk which is a rigid theory than fair game and concluded that for
market efficiency fair game is a sound enough model, RW not needed.