Chapter 10

EFFICIENT CAPITAL MARKETS

 Chapter 10 Questions
• What do we mean when we say that capital
markets are efficient?
• Why should capital markets be efficient?
• What factors contribute to an efficient market?
• Given the overall efficient market hypothesis
(EMH), what are the three subhypotheses and
what are the implications of each?
 Chapter 10 Questions
• How do we test the three efficient market
subhypotheses, and what are the results of the
tests?
• For each set of tests, which of the results
support the EMH and which indicate an anomaly
related to the hypothesis?
• What is behavioral finance, and how does it
relate to the EMH?
 Chapter 10 Questions
• What are some of the major findings of
behavioral finance, and what are the implications
for the EMH?
• What are the implications of the efficient market
test results for
– Technical analysis?
– Fundamental analysis?
– Portfolio managers with superior analysts?
– Portfolio managers with inferior analysts?
 Efficient Capital Markets
• In an efficient capital market, security
prices adjust rapidly to the arrival of new
information, therefore the current prices
reflect all information about the security
• Whether markets are efficient has been
extensively researched and remains
controversial
 Why does it matter?
• If prices do fully reflect all current
information, it would not be worth an
investor’s time to use information to find
undervalued securities.
• If prices do NOT fully reflect information,
FIND AND USE THAT INFORMATION,
and perhaps you will be able to make a
killing in the market.
 Investing and Market Efficiency
• Would stock selection
amount to throwing darts
at a wall in an efficient
market?
• Hardly! Risk still matters.
We would still want to
research the risk-return
properties of securities.
Why Should Capital Markets Be
Efficient?
• What would be the ingredients of an
“informationally” efficient market?
– A large number of profit-maximizing participants
analyze and value securities
– New information regarding securities comes to the
market in a random fashion
– Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
• Price adjustments are unbiased – correct on average.
• Under these conditions, a security’s price would
be appropriate for its level of risk.
 Alternative Efficient Market
Hypotheses
The various forms of the efficient market
hypothesis differ in terms of the
information that security prices should
reflect.
• Weak-form EMH
• Semistrong-form EMH
• Strong-form EMH
 Weak-Form EMH
• Current prices fully reflect all security-
market information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
• This implies that past rates of return and
other market data should have no
relationship with future rates of return
Implications of the Weak-From
EMH
• Examining recent trends
in price and other market
data in order to predict
future price changes
would be a waste of time
if the market is weak-form
efficient.
• A lot of people do price
charting and other forms
of “technical analysis.”
 Semistrong-Form EMH
• Current security prices reflect all public
information, including market and non-
market information
• This implies that decisions made on new
information after it is public should not
lead to above-average risk-adjusted profits
from those transactions
 Implications of the Semistrong-
Form EMH
• If the market is efficient in
this sense, information in
The Wall Street Journal,
other periodicals, and
even company annual
reports is already fully
reflected in prices, and
therefore not useful for
predicting future price
changes.
 Strong-Form EMH
• Stock prices fully reflect all information from
public and private sources
• This would require perfect markets in which all
information is cost-free and available to
everyone at the same time (which is clearly not
the case)
• Implication: Not even “insiders” would be able to
“beat the market” on a consistent basis