EFFICIENT MARKET

HYPOTHESIS
 EFFICIENT MARKET HYPOTHESIS

• What does it say?

• Three forms of market efficiency
• - Weak-form
• - Semi strong-form
• - Strong-form
• Empirical tests of market efficiency
• Test of RWH: Serial correlation tests, variance ratio tests
• Event study
• Strong-form test
• Does stock price reflect fundamental or fair values?
• Implications of market efficiency
• Conclusions?
 What does it say?
• Efficient Market Hypothesis has been developed
by Prof. E. Fama.
• Share prices fully reflect all available information
and prices are equal to their intrinsic, or
fundamental or fair values.
• New information comes into the market and it
will be reflected into share price instantly and
constantly.
• Since information will come randomly, price will
move randomly around the intrinsic or fair
values.
 Random Walk with Positive Trend

• Security Price

• Intrinsic or Fair value

• Price

• Time
 Fama classified market efficiency on the
basis of information set, into three groups:
• Weak-Form Efficiency;
• Semi-Strong Form Efficiency; and
• Strong-Form Efficiency
 Weak-Form Efficiency
• Current market price reflects all
information of past history of security
price.
• It should not be possible to make
consistent excess returns on securities by
using the past history of share price
movement.
• Information Set  = Past Information
 Semi-Strong-Form Efficiency
• Current prices instantly and fully reflect all
publicly available information.
• It is not possible to make consistent
excess returns on securities by using
publicly available information.
• Information Set  = Past as well as
Publicly available Information
 Strong-Form Efficiency
• Current market prices instantly and fully
reflect all information (Past, Public and
Private).
• Even directors or insider with access to
privileged inside information should not be
able to make consistent excess returns.
• Information Sub-Set  = Past, Public and
Private Information
THREE FORMS OF MARKET EFFICIENCY

EMH FORM INFORMATION SUB-

SET ()
Weak a
Semi-Strong a+b
Strong a+b+c
Where,
a = Past Securities Prices Information
b = Generally Available Public Information
c = Privately Held (Monopolistic or Insider) Information
 Different Forms of M.E.

Semistrong Weak Form

Strong Form
Form
 EMPIRICAL TESTS OF MARKET EFFICIENCY:

• The test of the weak-form hypothesis

• Whether all information contained in historical prices of securities is
fully reflected in current prices and whether it is possible consistently
to earn excess return on the basis of past information.

• The test of the semi strong -form hypothesis

• Whether publicly available information is fully reflected in current
stock prices and whether it is possible consistently to earn excess
return on the basis of publicly available information.

• The test of the strong-form hypothesis

• Whether all information, past, public and private (or inside), are fully
reflected in security prices and whether any type of investor is able
to earn excess returns.
 WEAK-FORM TESTS
• The weak-form of efficiency test has also been
designated in the literature as test of ‘Random Walk
Hypothesis’ (RWH).

• The applicability of Random Walk Hypothesis implies

that stock prices are independent and one is unable to
identify a pattern.

• One way of testing the RWH could be to check for

correlation in increments of prices or increments of log
prices (i.e., return) , which implies that if the
increments in prices or returns are uncorrelated, then
the random walk hypothesis holds and vice versa.
 WEAK-FORM TESTS
• Serial Correlation Test
• L-J Box Statistics
 Calculation of rate of return
• The rate of return is simply the logarithmic difference of
closing prices of two successive periods and
symbolically measured as

In(Pt/Pt-1),
where, Pt and Pt-1 are closing prices on two successive
days t and t-1.

The mathematical definition of return,

Rt = In (Pt/Pt-1).100 has been established by the
reasoning stated below.

•
 Calculation of rate of return
• Suppose at period t-1, the price of a share is Pt-1
and at period t, the price is Pt .
• Now, if return accrues @r% from period t-1 to
period t, then,
Pt = Pt-1 (1+r).
• If return accrues semi-periodically, on compound
basis, the terminal value at the end of the period
t would be,
Pt = Pt-1 (1+r/2) 2.
 Calculation of rate of return
• The terminal value at the end of the period t, for a share price (at
period t-1) compounding ‘m’ times a period is,

Pt = Pt-1 (1+r/m) m

When, m  
Pt = Pt-1 Lt (1+r/m) m
m

= Pt-1er [Since, Lt (1+r/m)m = er]

m

or, er = Pt / Pt-1
or, r = In (Pt/Pt-1).
 Correlation between successive price change in an

inefficient market
• Return on day t+k

• x x xx
• x x xx xx
• x xx x x x x
• x x x xxx
• x x xx x xxx x
• x x x x xx
• x x x x x
• x x xxx
• x x xx x
• x xxx x
• x x xx x
• x x xx x xxx
• x x xxx x xxx x
• x x x x x x
• x x x x x x

• Return on day t
 Correlation between successive price change in an efficient market

• Return on day t+k

• XX
• XXX X
• XXXXXX
• XX X X
• XXX

• Return on day t
•
 Serial Correlation Test (Auto Correlation Test):

• rt = In( Pt – Pt-1)

• Serial Correlation between rt and rt-1.

• rt rt-1
• r2 r1
• r3 r2
• r4 r3
• . .
• . .
• . .
• rn rn-1
• The serial correlation coefficient (rk) is estimated by

• rk = ck / c0
• Where ck = 1/n Σ (Xt - µ) (Xt+k -µ) where k = 0,1,2…….
• µ = 1/n Σ Xt

• And C0 = 1/n Σ (Xt - µ)2

• To test the joint hypothesis that all the serial correlation of the
residuals for lags 1 through m, are simultaneously equal to
zero, one can use Ljung-Box (LB) statistics developed by Ljung
and Box (1978), which is defined as
•
n(n  2)rk 2
LB  follows  2 with n d . f .
(n  k )
• Where n = Sample Size, and k = Lag Length
• If LB > Critical Value from Chi square
table at chosen level of significance,
• reject h0: All rk = 0
• at least sum of them must be non zero.
•  Violates the assumption of the RWH.
 SAMPLE DATA AND TIME PERIOD
of an unpublished paper
• Daily closing prices of BSE Sensex for the
period January 1991 to December 2001.
• Daily adjusted closing prices of thirty
underlying individual companies included
in the Sensex as on December 31, 2001.
Serial Correlation Test (Daily Index Data)

Lag and LB stat Serial correlation

1 .065*
2 .022
3 .007
4 .030
5 -.020
6 -.052*
7 .058*
8 -.019
9 .098*
10 .042*
11 -.001
12 -.024
13 -.037
14 .033
15 .021
16 .057*
17 -.011
18 -.007
19 -.055*
20 -.022
LB 85.608*
Serial Correlation Test (Daily Data on
Individual Cos.)
Lag and LB stat No. of companies
where correlations are
significant
Lag 1 19
Lag 2 & 3 4
LB stat 25 companies
Mixed results
 Market Anomalies
• Day of the week effect
• Turn-of-the month effect
• Holiday effect
• Month of the year effect (January
Effect)
• Karmakar, M and M Chakraborty “Stock Market
Anomalies: Evidence from India”, Prajnan,
Journal of Social and Management Science,
Vol.XXXII, No.1 April-June 2003, 37-53.

• Sample Data consist of ET daily price index

compiled and published the Economic Times for
the period from January 1981 to December
1995.
 Day of the week effect

Mean Daily Returns by Day of the Week for the

whole period (1981-95)

0.3
Mean daily returns

0.25
0.2
0.15
0.1
0.05
0
-0.05
Mon Tues Wed Thurs Fri
Day of the w eek
 Turn-of-the month effect
Difference of means test comparing average daily return at the turn of the
month with average daily return on remaining days of the month

Average return on turn-of- Average return on

the montha remaining calendar daysb
Mean (µ) 0.18314 0.05027

Std. Deviation 1.04557 0.96826

No. of observations 289 2781

• t-statisticc = 2.20237

• aThe period includes the last two calendar days (30, 31) of the previous month and the first two
calendar days (1,2) of the current month.
• bThe remaining calendar days include 3 to 29 calendar days of the mont

• cP (t>1.645/  = ) = 0.5 (one tail)

 Holiday effect
Mean daily returns by different categories of
days for the whole period
Mean daily returns

0.3
0.2
0.1
0
Week Pre Intra pre
Different categories of days
 Size effect (Small firm effect)
Why does the small firm effect concentrate in January?
 Do market anomalies challenge the concept of market efficiency?

• Recently many anomalies have disappeared from the

market.
• Market participants might have traded based on the
findings of market anomalies and made the market
efficient.
• Many of the predictable patterns that have been
discovered may simply be the result of data mining.
• The published literature is likely to be biased in favour of
reporting exciting results.
• Significant effects are likely to be published in
professional journals while negative results, or boring
confirmations of previous findings, are relegated to the
file drawer or discarded.
• Richard Roll, an academic financial economist who is also a
portfolio manager once responsed in a symposium on volatility in
US and Japanese stock markets as follows:

• “I have personally tried to invest money, my client’s money and my

own, in every single anomaly and predictive device that academics
have dreamed up….. I have attempted to exploit the so-called year-
end anomalies and a whole variety of strategies supposedly
documented by academic research. And I have yet to make a nickel
on any of these supposed market inefficiencies….. a true market
inefficiency ought to be an exploitable opportunity. If there’s nothing
investors can exploit in a systematic way, time in and time out, then
it’s very hard to say that information is not being properly
incorporated into stock prices.”
 Semi strong -form test

• Event study
• The idea behind such study is to see how
quickly and accurately news is incorporated into
the share price.
• If the EMH holds, then the effect of news will be
immediately and instantaneously incorporated
into the market price of a security which will
jump on the announcement of the new
information to a new fundamental value as
depicted in the following figure.
 Semi strong -form test
Event study
• Share Price

• EMH
•

• News Time

• The impact of news according to EMH

 Semi strong -form test
Event study
• Share Price
• If the market is
• overreaction
inefficient then a
• variety of other
• EMH scenarios are
• Under reaction
possible i.e., there
may be overreaction
•
or under reaction.

• News Time
• The impact of news if market is not
efficient
 Semi strong -form test
Event study
• Share Price • If the market consistently
overreact to new
• overreaction information, it would pay
• investors to go short on
stocks which are affected
• by good news, and buy
EMH
stocks adversely affected
• by bad news.
•

• Time
• The impact of news if market is not
efficient
 Semi strong -form test
Event study
• Share Price • Conversely, if the market
consistently under-reacts
• to news then it would pay
• investors to buy stocks
affected by good news
• and sell or go short in
EMH
stocks adversely affected
• Under reaction by bad news.
•

• Time
• The impact of news if market is not
efficient
 METHODOLOGY OF EVENT STUDIES

• 1. Collect a sample of firms that had a surprise

announcement (the event): Announcement of
Stock split or M&A.
• 2. Determine the precise day of the
announcement and designate this day as zero.
• 3. Define the period to be studied.
• If we studied 20 days around the event, then we would designate
–10, -9, -8, ………., -1 as the 10 days prior to the event, 0 as the
event day, and +1, +2, …….., +10 as the 10 days after the event.
• 4. For each of the firms in the sample, compute the
return on each of the days being studied.

• 5. Compute the excess return for each of the days

being studied for each firm in the sample.

• Actual Return – Expected Rate

• Ei,t = Ri,t – E(Ri)
• where Ri,t = actual return
• and E(Ri)= a + iRm = expected return if CAPM is
followed
• 6. Compute for each day in the event period the
average excess return for all the firm in the
sample.

• Expected Et =

 Ei, t
i 1
M
• 7. Cumulative Abnormal Return
k

•  Expected ( Et)
t 1

• In the case for a 21 day period (10 before the

event day, and 10 days after) the entry for –8
would be the sum of daily average excess
returns for days –10 to –8 and the entry for -5
would be the sum of the average daily excess
returns for -10 to -5.
 Stock Price response to new information in a semi strong-form efficient market

• Cumulative Expected Et

• +8
• +7
• +6
• +5
• +4
• +3
• +2
• +1
• 0

• -10 -8 -6 -4 -2 0 +2 +4 +6 +8 +10
• Days relative to announcement days
 Stock Price response to new information in efficient market (semistrong form)

• Cumulative Expected Et

• -10 -8 -6 -4 -2 0 +2 +4 +6 +8 +10
 Excess return prior to the announcement
day can come from three sources:
• First, the fact that an important announcement will take
place is often released to the public prior to the
announcement. In an efficient market this should be
reflected in price before the announcement takes
place.
• Firms split their stock generally after a substantial price
rise. Hence, studies of stock splits will find abnormal
returns prior to the announcement because firms with
abnormal returns are more likely to split their shares.
• Abnormal returns prior to the announcement day could
reflect leakage of the information by those with access
to it.
 STRONG FORM EFFICIENCY
• Insider Trading
• Director’s/Managers’ Share Purchases.
• One way of testing for strong-form market efficiency is to
look at the effects of share purchases by directors and
managers of companies, which they run.
• One would expect insiders to purchase shares before
any price rises and sell shares in advance of price falls.
• If it is found that they earn excess return from their
purchases/sales, it is suggested that strong-form of
market efficiency is rejected.
 Does price reflect fundamental or
fair value?

• Noise Trading
• If market is perfectly efficient and there is no noise in
price, no one would buy and sell the shares and market
would eventually collapse (Fisher Black).

• Fads or Bubble
• Behavioral Finance
 Implications of Test Results
• Whether market is efficient or inefficient?
– More relevant question is
“How efficient is the market?” or “What is
the degree of market efficiency?”
• True anomalies or data mining
• Behavioral Interpretation
– Inefficiencies exist
– Caused by human behavior
 EMH vs. FUNDAMENTAL AND
TECHNICAL ANALYSIS
• There are three broad theories concerning
stock price movements.
• These are
• - Fundamental analysis,
• - Technical analysis and
• - Efficient market analysis
 Fundamental analysis

 
Dt 
If Fundamental Value   P     Actual Pr ice
t 
 t 1 (1  K ) 

• The security is under-priced.

• The investment strategy is to buy the security.

• If Fundamental value < Actual price, the security is overpriced.

• The strategy is to sell the share.
 Technical analysis
• They believe that history repeats itself.
Hence, they try to predict future
movements in share prices by studying the
historical patterns in share price
movements.
• They suggest the timings for buying and
selling the shares
 EMH
• We have seen that the efficient market
hypothesis is expressed in three forms:
• Weak-Form;
• Semi-Strong Form; and
• Strong Form.
 Weak-form market efficiency and
technical analysts
• If the weak-form of market efficiency is to
hold then it is not possible to earn excess
return by using the past data.
• Thus the chartist and technical analysts
can not survive.
 Semi-strong market efficiency and
Fundamental Analysts
• If semi-strong form of market efficiency
were to hold then any new publicly
available information gets instantly
incorporated into share price and there is
no chance to profit from this information.
• This would suggest that investment and
research analysts (Fundamental Analysts)
will not be able to produce excess return.
 Strong-form market efficiency and
Insider Trading

• The strong form of market efficiency

implies that even private or inside
information will be reflected in share price
and it is not possible for insiders also to
earn excess return.
• If it were to hold, there is no need for
government to have “Insider Trading”
Laws.
 Empirical evidence in brief

• In most of the countries, weak-form market

efficiency holds and it is a challenge to
technical analysts and chartists.
• The evidence in support of semi-strong
market efficiency is relatively weak.
• Finally, the evidence of strong form
efficiency is almost nil.
 The Current State of Efficient Markets

• What can we conclude about the Efficient

Markets Hypothesis?
• Amazingly, there is still no consensus
among financial economists.
• There is an old story, widely told among financial
economist, about a finance professor strolling
down the street with a student when they come
upon a $100 bill lying on the ground.
• As the student reaches down to pick it up, the
professor says “Don’t bother – if it were a real
$100 bill, someone would have already
picked it up.”
 IMPLICATION OF MARKET
EFFICIENCY:

• Implications for Economy

• - Social cost
• - Misallocation of capital
 THE PARADOX
• The paradox of efficient markets is that if
every investor believed a market was
efficient, then the market would not be
efficient because no one would analyze
securities.
• In effect, efficient markets depend on
market participants who believe the
market is inefficient and trade securities in
an attempt to outperform the market.
 Conclusion?
• In reality, markets are neither perfectly
efficient as rational expectation theorists
believe nor completely inefficient as
behaviour finance theorists claim.
• Rather than being an issue of black
• or white ,
• market efficiency is more a matter of
shades of gray .