The Efficient Capital Markets
By Ding zhaoyong
Main Contents
The concept of efficient capital markets
Alternative efficient market hypotheses
The tests and results of EMHs
The implication of EMHs
Efficient Capital Markets
Efficient capital market is one in which
security prices adjust rapidly to the
arrival of new information and,therefore,
the current prices of securities reflect all
information about the security.
Efficient Market Hypotheses (EMH ) are
those alternative hypotheses which
consider the efficiency of the markets
Efficient Capital Markets
An efficient capital market imply:
– A large number of competing profit-
maximizing participants analyze and
value securities,each independently of
the others.
– New information regarding securities
comes to the market in a random
fashion,and the timing of one
announcement is independent of others
Efficient Capital Markets
– The competing investors attempt to
adjust security prices rapidly to reflect
the effect of new information,although
imperfect and unbiased.
– The security prices that prevail at any
times should be an unbiased reflection
of all currently available information,
The expected returns implicit in the
current price should reflect its risk.
Efficient Capital Markets
Random walk hypothesis
– the notion that stock prices changes are
random and unpredictable.
– Dealing with price movement over time
Efficient market hypothesis
– the notion that stock prices already
fully reflect all available information,
– The fair game model( specified time)
Efficient Capital Markets
Investors will have an incentive to spend
time and resources to analyze and
uncover new information only if such
activity is likely to generate high returns
Competition among many well-backed,
highly paid,aggressive analysts ensure
stock prices ought to reflect available
information regarding their proper levels
Alternative EMHs
The weak-form EMH assumes that stock
prices fully reflect all security-market
information.
– Including the historical of price,rates
of return,trading volume data,and
other market-generated information,
such as block trades,short interest,
odd-lot transactions.
Alternative EMHs
The semistrong-form EMH asserts that
security prices adjust rapidly to the
release of all public information.
– Public information includes all market
and non-market information,such as
earnings and dividend announcement,
P/E ratios,D/P ratios,BV/MV ratios,
product line,patent held,economic
news,political news,etc.
Alternative EMHs
The strong-form EMH contends that
stock prices reflect all information from
public and private sources relevant to the
firm,including information available
only to company insider.
– It extends the assumption of efficient
markets to assume perfect markets in
which all information is cost-free and
available to everyone at the same time.
Tests of the EMHs
The difficulties of EMH tests
– The magnitude issue:only managers of
large portfolios can earn enough
trading profits to make the exploitation
of minor mispricing worth the effort.
– The selection bias issue,we can not
fairly evaluate the true ability of
portfolio managers to generate winning
stock market strategies.
Tests of the EMHs
– The lucky event issue,any bet on a
stock is simply a coin toss,If many
investors using a variety of schemes
make fair bets,statistically speaking,
some of those investors will be lucky
and win a great majority of bets.
Test of Weak-Form EMH
Returns over short horizon
– test of the efficiency of technical analysis
– runs analysis of stock price
– serial correlation in stock returns
– filter rule analysis
Returns over long horizon
– long-term serial correlation
Test of Semisrtong-Form EHM
D/P ratios analysis
P/E effect
The small-firm effect
The January effect
The neglected-firm and liquidity effect
Market-to-book ratios
Reversal effect
The day-of-week effect
Test of Strong-Form EHM
Inside information
The value line enigma
The market crash
Mutual fund performance
– performance across section
– performance across time
Implications of the EMHs
The EMH and Technical Analysis (TA)
– TA is the search for recurring and
predictable patterns in stock prices
– The assumption of gradually response
of stock prices to events is opposed to
the notion of an efficient market
– One should not expect abnormal
returns through TA if EMH is true.
Implications of the EMHs
The EMH & Fundamental Analysis(FA)
– The EMH predicts that most FA adds
little value.
– One can make money only if his
analysis is better than that of his
competitors because the market price
is expected already to reflect all
commonly available information.
Implications of the EMHs
The EMH & Portfolio Management(PM)
– Only serious,time-consuming,and
expensive technique are likely to
generate the differential insight
necessary to generate trading profit.
– Active PM is largely wasted effort
– Passive PM and Index fund
Implications of the EMHs
The EMH and the role of PM
– Portfolio selection,diversification v.s,
Firm-specific risk
– Tax consideration for specific client
– Particular risk profile of the investor
– Other factors,age,employment
– Tailor the portfolio to above needs,
rather than to attempt to beat the
market.
By Ding zhaoyong
Main Contents
The concept of efficient capital markets
Alternative efficient market hypotheses
The tests and results of EMHs
The implication of EMHs
Efficient Capital Markets
Efficient capital market is one in which
security prices adjust rapidly to the
arrival of new information and,therefore,
the current prices of securities reflect all
information about the security.
Efficient Market Hypotheses (EMH ) are
those alternative hypotheses which
consider the efficiency of the markets
Efficient Capital Markets
An efficient capital market imply:
– A large number of competing profit-
maximizing participants analyze and
value securities,each independently of
the others.
– New information regarding securities
comes to the market in a random
fashion,and the timing of one
announcement is independent of others
Efficient Capital Markets
– The competing investors attempt to
adjust security prices rapidly to reflect
the effect of new information,although
imperfect and unbiased.
– The security prices that prevail at any
times should be an unbiased reflection
of all currently available information,
The expected returns implicit in the
current price should reflect its risk.
Efficient Capital Markets
Random walk hypothesis
– the notion that stock prices changes are
random and unpredictable.
– Dealing with price movement over time
Efficient market hypothesis
– the notion that stock prices already
fully reflect all available information,
– The fair game model( specified time)
Efficient Capital Markets
Investors will have an incentive to spend
time and resources to analyze and
uncover new information only if such
activity is likely to generate high returns
Competition among many well-backed,
highly paid,aggressive analysts ensure
stock prices ought to reflect available
information regarding their proper levels
Alternative EMHs
The weak-form EMH assumes that stock
prices fully reflect all security-market
information.
– Including the historical of price,rates
of return,trading volume data,and
other market-generated information,
such as block trades,short interest,
odd-lot transactions.
Alternative EMHs
The semistrong-form EMH asserts that
security prices adjust rapidly to the
release of all public information.
– Public information includes all market
and non-market information,such as
earnings and dividend announcement,
P/E ratios,D/P ratios,BV/MV ratios,
product line,patent held,economic
news,political news,etc.
Alternative EMHs
The strong-form EMH contends that
stock prices reflect all information from
public and private sources relevant to the
firm,including information available
only to company insider.
– It extends the assumption of efficient
markets to assume perfect markets in
which all information is cost-free and
available to everyone at the same time.
Tests of the EMHs
The difficulties of EMH tests
– The magnitude issue:only managers of
large portfolios can earn enough
trading profits to make the exploitation
of minor mispricing worth the effort.
– The selection bias issue,we can not
fairly evaluate the true ability of
portfolio managers to generate winning
stock market strategies.
Tests of the EMHs
– The lucky event issue,any bet on a
stock is simply a coin toss,If many
investors using a variety of schemes
make fair bets,statistically speaking,
some of those investors will be lucky
and win a great majority of bets.
Test of Weak-Form EMH
Returns over short horizon
– test of the efficiency of technical analysis
– runs analysis of stock price
– serial correlation in stock returns
– filter rule analysis
Returns over long horizon
– long-term serial correlation
Test of Semisrtong-Form EHM
D/P ratios analysis
P/E effect
The small-firm effect
The January effect
The neglected-firm and liquidity effect
Market-to-book ratios
Reversal effect
The day-of-week effect
Test of Strong-Form EHM
Inside information
The value line enigma
The market crash
Mutual fund performance
– performance across section
– performance across time
Implications of the EMHs
The EMH and Technical Analysis (TA)
– TA is the search for recurring and
predictable patterns in stock prices
– The assumption of gradually response
of stock prices to events is opposed to
the notion of an efficient market
– One should not expect abnormal
returns through TA if EMH is true.
Implications of the EMHs
The EMH & Fundamental Analysis(FA)
– The EMH predicts that most FA adds
little value.
– One can make money only if his
analysis is better than that of his
competitors because the market price
is expected already to reflect all
commonly available information.
Implications of the EMHs
The EMH & Portfolio Management(PM)
– Only serious,time-consuming,and
expensive technique are likely to
generate the differential insight
necessary to generate trading profit.
– Active PM is largely wasted effort
– Passive PM and Index fund
Implications of the EMHs
The EMH and the role of PM
– Portfolio selection,diversification v.s,
Firm-specific risk
– Tax consideration for specific client
– Particular risk profile of the investor
– Other factors,age,employment
– Tailor the portfolio to above needs,
rather than to attempt to beat the
market.
