6. The Efficient Market Hypothesis

Transcription

1 6. The Efficient Market Hypothesis University of Paris 6 Based largely on Bodie, Kane & Markus: Essentials of Investments, 4 th Edition, McGraw Hill International, ch. 9 And Shapiro and Balbirer: Modern Corporate Finance, Prentice Hall 1 The Efficient Market Hypothesis! Background Concepts! The Hypothesis! Implications of the EMH! Empirical Testing 2

2 Background Concepts! Arbitrage! Risk-adjusted returns! Rational Expectations! Random Walk 3 Rational Expectations! Price reflects expectations! Good companies prices are already high! Rational expectations include all known information! Only «news» or «surprises» are left to be incorporated 4

3 Random Walk! Random Walk - stock prices are random (unpredictable) Actually!Expected price is positive over time!positive trend and random about the trend 5 Security Prices Random Walk with Positive Trend 9-4 Time

4 Random Price Changes! Why are price changes random? Prices incorporate all information and expectations Only surprises are left to be incorporated. Prices react to «surprise» information «Surprise» information is random Therefore, price changes are random 7 Efficient Market Hypothesis (EMH)! Do security prices reflect information?! Why look at market efficiency If prices were predictable, everybody would buy (or sell) now - Prices would change immediately - No advantage in buying 8

5 EMH and Competition! Stock prices fully and accurately reflect publicly available information! Once information becomes available, market participants analyse it! Arbitrage and Competition assure prices reflect information 9 Cost of Information! The cost of research and analysis is an investment which should give returns! If the ROI on information gathering is high, everyone would do this.! So, ROI on information gathering would reduce! Prices would respond fast to available information 10

6 Forms of the EMH Semistrong form Weak form! Weak Securities covered Strong Form Prices reflect available information about securities! Semi-strong Prices reflect all publicly held information! Strong Prices reflect all available information, even inside information assumptions Semistrong form Weak Form Strong form 11 Technical Analysis! Using prices and volume information to predict future prices! Example: Filter rules 12! Weak form efficiency & technical analysis EMH: Zero Correlation between one period prices and next period return! Any signals contained in stock-price data is useless since everyone would use it instantly.! Signals lose value once they are widely known.! Technical Analysis is therefore useless Technical Analysts:! Markets are sluggish and leave time to discern common trends! If pattern can be identified, it can be exploited

7 Fundamental Analysis! Using economic and accounting information to predict stock prices Past prices, products, quality of management, balance sheet, patents, forecasts, accounting practices But all good companies will have high share prices. The idea is to find mis-priced securities 13! Semi strong form efficiency & fundamental analysis EMH:! If such information is publicly available all will use information immediately.! Fundamental analysis is useless ( Zero Correlation between (eg.) ratio analysis and next period returns) Fundamental Analysts! If one is large enough, one can have better analysis Implications of Efficiency For Passive Management! Passive Management Buy and Hold!Well-diversified folio Index Funds!Follow the market 14

8 Implications for Active Management! Active Management Security analysis! Only the biggest can afford superior research! Small investors should pool into mutual funds! Ensure that even a passive portfolio is well- diversified to minimise risk! The mix with risk-free asset for each individual to represent his riskpreference Timing! Tax considerations: tax-free bonds, capital gains v. dividends! Liquidity needs 15 Weaknesses of the EMH! Lack of Perfect information! Lack of competition! Over-reaction and correction! If no one reacts, how do corrections take place?! The early bird may still get a worm 16

9 SEC Involvement to correct weaknesses! Information has to be provided! Companies have to follow GAAP! Trading Commissions are falling! Insider Trading prohibited! Price manipulation prohibited 17 Problems created by SEC involvement! Many small shareholders means no control on managers! Insider trading rules restrict free flow of information! Managers cannot debate strategies in public 18