final Efficent market.pptx including anomalies

Efficient Market Hypothesis

1. Lecture Efficient market hypothesis

2. Efficient market hypothesis Eugene Fama ( EMH ) (1970) (Efficient market hypothesis ) He defines an efficient market as: ‘A market in which prices always “fully reflect” available information is called “efficient.”’ Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available. The EMH states that an investor can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged away.

3. To understand how expectations affect securities prices we need to look at how information in the market affects these prices To do this we examine the efficient market hypothesis The application of the theory of rational expectation to financial market is called the efficient market hypothesis which states that current security prices fully financial reflect all available information because in EM all unexploited profit opportunities are eliminated The EMH states that securities are typically in equilibrium or that are fairly priced. I ntrnisic price Pv = benfit + discount

4. Efficient market hypothesis 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 the expected return on a security (the interest rate) 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 R e equals the equilibrium return R *, which equates the quantity of the security demanded to the quantity supplied; that is , RRt e = equilibrium return RRt * Replace RRt e with RRt * optimal forecasted Return= equilibrium return RRt of = RRt *

5. Efficient market hypothesis RRt of = RRt * 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.

6. Why efficient market hypothesis makes sense Demand increase (buy) supply increase (sell) Arbitrage :All unexploited profit opportunities eliminated Efficient market condition holds even if there are uninformed, irrational participants in market

7. To see why the efficient market hypothesis makes sense, we make use of the concept of arbitrage, in which market participants ( arbitrageurs ) eliminate unexploited profit opportunities, meaning returns on a security that are larger than what is justified by the characteristics of that security.

8. To see how arbitrage leads to the efficient market hypothesis , suppose you own stock that has equilibrium return of 10%. R*= 10 % Also assume that the current price of this stock is lower than the optimal forecast of tomorrow’s price . so that the optimal forecast of the return at an annual rate is 50 %, which is greater than the equilibrium return of 10 % Rof =50% Rof > R* 50% > 10% RETURN high….>……PRICE low ……(buy)….> demand increase……..>…..PRICE increase………> RETURN decrease up to the equilibrium return INVERSE RELATION B/w PRICE AND RETURN

9. We are now able to predict that, on average , ABC return would be abnormally high, so there is an unexpected profit opportunity. Knowing that, on average, you can earn such an abnormally high rate of return on ABC because R of > R *, you would buy more, which would in turn drive up its current price relative to the expected future price , thereby lowering R of . When the current price had risen sufficiently so that R of equals R * and the efficient market condition satisfied. the buying of ABC will stop, and the unexploited profit opportunity will have disappeared.

10. Similarly, a security for which the optimal forecast of the return is 5 % while the equilibrium return is 10% ( R of < R *) would be a poor investment because, on average, it earns less than the equilibrium return 5% < 10% RETURN LOW….>..PRICE HIGH…(sell)…….> supply increase……..> ….PRICE REDUCED ………..> RETURN INCREASE up to the equilibrium return In this case you would sell the security and drive down its current price relative to the expected future price until R of rose to the level of R * and the efficient market condition is again satisfied

11. If overpriced: people will start selling, which would increase supply and prices would come down due to excess of supply. If underpriced: people will start buying, which would increase demand and prices would come down due to excess of demand

12. Financial markets are structured so that many participants can play. As long as a few (who are often referred to as “smart money”) keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear because in so doing, they make a profit . The efficient market hypothesis makes sense because it does not require everyone in a market to be cognizant of what is happening to every security.

13. Efficient market hypothesis The efficient market hypothesis posits that the market cannot be beaten because it incorporates all important information into current share prices.  Therefore, stocks trade at the fair value, meaning that they can't be purchased undervalued or sold overvalued . Though the efficient market hypothesis theorizes the market is generally efficient, the theory is offered in three different versions: weak, semi-strong, and strong.

14. Assumptions 1- All market participants have equal access to historical data on stock prices, and both public and private information is available. This condition proves that no arbitrage opportunity is available. Thus, none of the investors has an advantage over the others in making investment decisions. 2- The efficient market hypothesis only holds if investors are rational, i.e., investors are risk averse. To put it simply, if there are two investments of the same return but of different risk, a rational investor will always prefer the one with lower risk.

15. Assumption 3 It is impossible to beat the market in the long run, which means that it is impossible in the long term to consistently receive returns higher than the market average . The efficient market hypothesis also assumes that there is no arbitrage opportunity, i.e., stocks are always traded in the market at their current fair value. In other words, it is impossible for any investor to earn arbitrage profit from buying undervalued stocks or selling overvalued stocks.

16. Assumption 4 Stock prices change randomly, i.e., trends or patterns in the past do not allow someone to forecast their movements in the future. Therefore, the efficient market hypothesis makes both technical and fundamental analysis completely useless

17. Eugene Fama in 1970 introduced the forms of efficient markets. He states markets function in three formats: Weak Semi-strong Strong The forms are described with respect to available information that is reflected in the price

18. Weak form Weak form of market efficiency reflects past market data. The “Weak” form contends that all past market prices and data are fully reflected in securities prices; that is, technical analysis is of little or no value. Technical analysis is the use of past price movements to predict future price fluctuations. However, in the weak form of market efficiency, fundamental analysis and non-public information can be used to earn excess return. When the piece of securities is adjusted on the basis of historical information, then this information is available to everybody, and so, on the basis of that information, nobody can earn abnormal returns the weak form of market efficiency is that past price movements are not useful for predicting future prices. Therefore future price changes can only be the result of new information becoming available.

19. No investor can earn excess returns by developing on historical price/returns data. So technical analysis cannot beat the market. All past information is reflected in the current price of an asset. Based on this form of the hypothesis, such investing strategies such as technical-analysis based rules used for investing decisions should not be expected to persistently achieve above normal market returns. Within this form of the hypothesis there remains the possibility that excess returns might be possible using fundamental analysis (public information ) or inside information).

20. Semi strong form Semi-strong format reflects past market data and public information The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading on that new information. No investor can earn excess returns from trading rules based on any publicly available information. Implication is that all publicly available information is fully reflected in the actual asset price. Market reaction to new publicly available information is instantaneous and unbiased. No over- or under-reaction. Fundamental analysis based on publicly available information shouldn’t result in abnormal returns

21. This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve superior returns, because any information gained through fundamental analysis will already be available and thus already incorporated into current prices. Only private( inside information) information unavailable to the market at large will be useful to gain an advantage in trading, and only to those who possess the information before the rest of the market does. 

22. Semi-strong form implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no one should be able to outperform the market using something that "everybody else knows ". This indicates that a company's financial statements are of no help in forecasting future price movements and securing high investment returns. When the price of securities responds to the public information, the public information is available to everybody, and nobody can earn abnormal returns on the basis of this information Semi-strong form of efficiency is typically tested by studying how prices and volumes respond to specific events. If price reflect new information quickly, markets are semi-strong form efficient.

23. Strong form The strong format reflects in addition to past market data and public information, private information as well. In strong form of efficiency stock prices quickly reflect all types of information which include public information plus companies inside or private information. Thus, it is the combination of public and private information that is incorporated into current prices This form implies that even companies management can not make profit from inside information; they cannot take advantage of inside affairs or important decision or strategies to beat the market The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market Given the assumption that stock prices reflect all information (public as well as private), no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information. 

24. The “Strong” form contends that all information is fully reflected in securities prices; that is, insider information is of no value . The strong form of efficiency suggests that prices of securities reflect all available information (private or public information). When the price of securities responds to private information, this information is available to everybody, and so, on the basis of that information, nobody can earn abnormal returns . No investor can earn excess returns using any information – public or private. Strong form efficiency implies that all information is fully reflected in the price of the asset . merger or special dividend that have not yet been announced are two examples of insider information .

25. In an efficient market abnormal returns are defined as excess returns over expected returns given security risk and market return. It has been found though that investors do earn abnormal returns based on information available to them, a sign of an inefficient rather than an efficient market.

26. Anomalies Anomalies There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory An anomaly is a deviation from the normal situation. When the actual result is different from the expected result under a given set of assumptions, the outcome is said to be an anomaly

27. Evidence Against Market Efficiency ( anomolies ) January Effect The January Effect is the tendency of stock prices to experience an abnormal positive return in the month of January that is predictable and, hence, inconsistent with random-walk behavior. Investors have an incentive to sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns.

28. Small-Firm Effect The Small-Firm Effect is an anomaly. Many empirical studies have shown that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been considered Small market Capitaliation = no of share * share price 10 *10 =100 100*15=1500

29. Market Overreaction Market Overreaction: recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly Herarding When corporations announce a major change in earnings, say, a large decline, the stock price may overshoot, and after an initial large decline, it may rise back to more normal levels over a period of several weeks. This violates the EMH because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels.

30. Response of efficient market and inefficient market to good news

31. Mean Reversion Mean Reversion: Some researchers have found that stocks with low returns today tend to have high returns in the future, and vice versa. Hence stocks that have done poorly in the past are more likely to do well in the future because mean reversion indicates that there will be a predictable positive change in the future price, suggesting that stock prices are not a random walk. stock's price will tend to move to the average price over time

32. Behavioral finance One of the arguments of EMH is that unexploited profit is eliminated by knowledgeable investors. For this to happen they must engage in short selling. Short selling – borrowing the stock from brokers and then sell it in the market with the aim of making a profit by buying the stock back at a lower price. Psychologists suggest that people are subject to ‘loss aversion’. They are more unhappy from losses than happy with equivalent gains. Because the potential losses can be huge from short selling in reality short selling occurs only in special circumstances Disposition effect (sell winng stock too early and lossing stock sell too late ( ratiain ) Prospect theory (gain and losss )

33. Psychologists have also found that people tend to be overconfident in their own judgments ( everyone believes they are above average) investors tend to believe they are smarter than other investors. These “smart” investors not only assume the market often doesn’t get it right , but they are willing to trade on the basis of these beliefs. This can explain why securities markets have so much trading volume, something that the efficient market hypothesis does not predict

34. Overconfidence provide an explanation for stock market bubbles. When stock prices go up, investors attribute their profits to their intelligence. M ore investors think stock prices will rise in the future Prices continue to rise, producing a speculative bubble finally crashes when prices get too far out of line with fundamentals

35. Suppose that a share of Microsoft had a closing price yesterday of $80 , but new information was announced after the market closed that caused a revision in the forecast of the price for next year to go to $ 110. If the annual equilibrium return on Microsoft is 12%, what does the efficient market hypothesis indicate the price will go to today when the market opens? Microsoft pays no dividends .