Portfolio Analysis and Investment Management SECTION B QUESTION 3 Fama (1998) and Rubinstein (2001) suggest that market

efficiency survives the challenge from the literature on stock return anomalies. Discuss their arguments and explain the implication for investment practitioners.

ANSWER An anomaly provides evidence that a given assumption or model does not hold in practice. The existence of stock returns anomalies are not sufficient to either refute the efficient market hypothesis. Fama (1970) designed EMH theory with an empirical base, and distributed the Efficient Market Hypothesis into three hypotheses based on information. Fama divided the empirical tests of the hypothesis into three categories based on the given information set i. weak-form EMH, ii. Semi-strong-form EMH and iii. Strong-form EMH. According to EMH theory it is described that when investors face with new set of information they can overreact and some may under react to the forthcoming situation. In these scenario investors reactions are random behavior and trace a normal distribution pattern so that the net effect on market prices may not be reliably explored to make an abnormal profitable situation, when considering transaction costs i.e. commissions and spreads. This situation may be perceive by an investor in a wrong manner about the market indeed, thus in actual situation the market as an aggregate is always right. If the equity market is working efficiently, the prices will show the intrinsic values of the equity and in reply, the limited savings will be allocated to the productive investment sector optimally in such a way that will provide stream of benefits to the individual investors and to the economy of the country as a whole (Copeland and Weston 1988).

Rubinstein (1975) and Latham (1985) have made extension in the basic definition of market efficiency. According to them the market is efficient regarding to an information event if that information impacts no portfolio changes. Possibility is that people may not be agreeing with the conjecture of a piece of information so some can buy an asset and others may sell in such a way that the market price is not affected. If the information makes no change in prices then the market is termed as an efficient regarding to the information as Fama (1970) concluded but not by the Rubinstein (1975) or Latham (1985) sense. For investors specially, buying and selling strategies have to be designed by considering the prices are typified by random walks or by persistence in the short run and mean deterioration in the long run. Finally it is stated that if a stock market is inefficient, the pricing apparatus may not assure the efficient allocation of capital in an economy which effects negatively to the aggregate economy. Efficient Market Hypothesis is based upon the assumption that equity prices absorb speedily to the influx of latest information therefore present prices totally replicate whole existing information. On the basis of this theory, it does not seem possible to constantly perform extraordinarily in the market by applying any sort of information that is already known by the market, and the exception is only lucky element. In EMH any news or information is defined as anything which can affect prices that are not known in the current scenario and looks randomly in future perspective. Fama (1970) reported the EMH theory as a fair game model, which indicates that the investors are confident regarding to the current market price which fully replicates all available information regarding to a security. Moreover the expected returns are based upon this price which is consistent with its risk. Stock market efficiency suggests that stock prices incorporate all relevant information when that information is readily available and widely disseminated (a reasonable description of the U.S. stock market), which implies that there is no systematic way to exploit trading opportunities and achieve superior results. As such, purchasing stocks is a zero net present value proposition; you will be

compensated for the risk that you assume but no more, over time. Market efficiency does not say that stock prices are always correct, but it does say that stock prices are not mispriced in any kind of systematic or predictable way. One predicted outcome of the efficient markets hypothesis is modest trading activity and limited price fluctuations. As investors receive information and agree on its meaning, prices can adjust without substantial trading activity. Another assumption is that investors can treat expected stock price returns as independent, identically distributed variables unleashing probability calculus Rational investors are people who can quickly and accurately assess and optimize risk/reward outcomes. They are constantly seeking profit opportunities, and it is the very efforts of such investors to make money that lead to market efficiency. This framework of investor behavior is reflected in the Capital Asset Pricing Model (CAPM), which suggests a linear relationship between risk and return. The informational efficiency of stock prices If securities prices reflect all publicly available information in an unbiased way, then the following will result as traits of the securities markets: 1. Return predictability. The difference between realized returns and expected returns should not be predictable. There are two parts to thisa time series part and a cross-sectional part. The time series part says that investors should not be able to predict which time periods will produce abnormally high or low stock market returns. The cross-sectional part says that investors should not be able to predict which stocks are likely to have abnormally high or low returns during a subsequent period. In both cases, realized returns are compared to an estimate of expected returns to determine what part of the return is abnormal. 2. Financial market link to the real economy. Cross-sectional differences in expected return should be related to risk factors that have a meaningful effect in the economy. If a company's operating results are highly sensitive to a particular macroeconomic variable, and if this variable affects large segments of the economy, then the company's stock should earn a risk premium to compensate investors for this non-diversifiable risk. Sensitivity to pervasive risks in the real economy should be reflected in stock prices.1

3. Performance persistence. Professional money managers should not consistently be able to earn high returns by analyzing financial information. If the information is already reflected in securities prices, gathering and analyzing the available information should not provide a reliable payoff for investors. In any given period, some investors will realize high returns just by chance. But in an efficient market, certain skilled investors should not be able to profit consistently from their analytical abilities. For investors, the bottom line is that certain variables do appear to have predictive power for returns. However, it is not clear whether these variables are predicting abnormal returns or rational variation in expected returns. People on both sides of the efficiency debate interpret the results to support their views. Consequently, the empirical studies on predictability do not provide conclusive evidence either for or against the efficient markets hypothesis.