Prepared By: Satyawan Dhankhar Kumar Gautam Singh Satyendra Sinha Deverovat

Prepared By: Satyawan Dhankhar Kumar Gautam Singh Satyendra Sinha Deverovat Gorain Vikrant Singh Arun Kumar Paswan

Definition of Efficient Markets  An efficient capital market is a market that is efficient in processing

information.  We are talking about an “informationally efficient” market, as opposed to a

“transactionally efficient” market. In other words, we mean that the market quickly and correctly adjusts to new information.  In an informationally efficient market, the prices of securities observed at

any time are based on “correct” evaluation of all information available at that time.  Therefore, in an efficient market, prices immediately and fully reflect

available information.

A reasonable answer is that the price would change if investors obtain new information about the stock that causes them to revise their forecast about the stock’s future return. New information that causes investors to be more optimistic would cause them to revalue the stock price higher. Negative information would result in lower price revaluations.

The Efficient Markets Hypothesis The Efficient Markets Hypothesis (EMH) is made up of three

progressively stronger forms:  Weak Form  Semi-strong Form  Strong Form

The EMH Graphically… All historical prices and  In this diagram, the circles representreturns the amount of information that each form of the EMH includes.

Strong Form Semi-Strong

 Note that the weak form covers the

least amount of information, and the

Weak Form

strong form covers all information.  Also note that each successive form

includes the previous ones. All information, public and private

All public information

 It can be observed by the graph that market

is a weak efficient form , when historical information is available only.  when historical information and public information is available in the market then the market crosses into second level.  When all the information is available in the market then the market crosses into third level.

The Weak Form  The weak form of the EMH says that past prices, volume, and other market

statistics provide no information that can be used to predict future prices.  If stock price changes are random, then past prices cannot be used to forecast

future prices.  Price changes should be random because it is information that drives these

changes, and information arrives randomly.  Prices should change very quickly and to the correct level when new

information arrives .

 It asserts that the current price fully reflect the

information contained in the historical sequence of price series.  The future price can’t be predicted by analyzing the past price pattern by any participant.  The abnormally high profit can’t be yield by a devising any strategy based on information of past price.  Samulson(1965) argued that today’s price change reflect today’s news and independent of yesterday price change.

 Two hypothetical time series of return are plotted in Fig. By visual analysis we can conclude that return in

PANEL (A) are not generated by a weak form efficient market. Because return and five day lag return in panel A are highly correlated. But in Panel B ,No one can conclude any pattern so that it is a weak form efficient market. It means past historical information is helpful in Panel but not in Panel B.

Tests of the Weak Form  Serial correlations.  Runs tests.  Filter rules.  Many studies have been done, and nearly all support weak

form efficiency.

Serial Correlations  The following chart shows the relationship between S&P 500 returns each

month and the returns from the previous month. Data are from Feb. 1950 to Sept. 2001.  Note that the R2 is virtually 0 which means that knowing last month’s return

does you no good in predicting this month’s return.  Also, notice that the trend line is virtually flat (slope = 0.008207, t-statistic

= 0.2029, not even close to significant)  The correlation coefficient for this data set is 0.82%

Serial Correlations (cont.) Unlagged vs One-month Lagged S&P 500 Returns y = 0.008207x + 0.007451 2

R = 0.000067

Unlagged Returns

20.00% 10.00% 0.00% -10.00% -20.00% -30.00% -30.00%

-20.00%

-10.00%

0.00%

10.00%

One-month Lagged Returns

20.00%

It is used to find out whether the series of price movement have

occurred by chance.  The runs test analyzes the occurrence of similar events that are separated by events that are different. The test statistic is asymptotically normally distributed, so this program computes Z, the large sample test statistic, as follows: Z = (R – E(R)) / sqrt(V(R)) where R is number of runs. The expected value and variance of R are: E(R) =( 2nm / (n + m)+1 V(R) = ( 2nm(2nm – n – m )) / ((n + m)2 (n + m – 1)) where n is the number of positive runs and m is the number of negative runs.

 Acc. to this test, If price of a security rises by at least X%,

Investor should buy and hold the stock until it’s price decline by at least X%. Example:- Hudson in 1996 tested the financial time industry ordinary index (U.K) in the period from 1935 to 1994.  In conclusion hudson asserted that filter rule does not permit excess return in the U.K market. It seems to support the weak form efficiency of the U.K financial market.

The Semi-strong Form  It asserts that current price of the stock not only fully

reflect the past price information but also all current publically information.  It tests whether there are abnormal returns associated with

the issuance of information to the public.  if the price can’t react to the new information properly,

there is chance to make abnormal profit.

Tests of the Semi-strong Form Event Studies Stock splits Earnings announcements Analysts recommendations

Suppose that initial price of the share is X(In fig.) There is a announcement of a big company about profit

above expectation.  Now new price of the share is Y. The price under reacts to the information initially going to Y1(XY)

The Strong Form  The strong form says that current prices fully reflect all information.  Corporate insiders are suspected of having privileged information.  There is a building concentric model to detect insider trading.

Tests of the Strong Form Corporate Insiders. Specialists. Mutual Funds. Studies have shown that insiders and specialists often earn

excessive profits, but mutual funds (and other professionally managed funds) do not. In fact, in most years, around 85% of all mutual funds

underperform the market.

Mutual Fund Performance Generally, most academic studies have found that mutual

funds do not consistently outperform their benchmarks, especially after adjusting for risk and fees. Example. Jenses in (1969) evaluate the performance in U.S market over the period from 1955 to 1964. it was found tha average return were below ths sharp-linter market line.when fees and costs were added back the average funds were scatterd.

Anomalies Anomalies are unexplained empirical results that

contradict the EMH: The Size effect. The “Incredible” January Effect. P/E Effect. Day of the Week (Monday Effect).

The Size Effect  Beginning in the early 1980’s a number of studies found that

the stocks of small firms typically outperform (on a riskadjusted basis) the stocks of large firms.  This is even true among the large-capitalization stocks within

the S&P 500.

The smaller (but still large) stocks tend to

outperform the really large ones.

The “Incredible” January Effect Stock returns appear to be higher in January than

in other months of the year. This may be related to the size effect since it is

mostly small firms that outperform in January. It may also be related to end of year tax selling.

The P/E Effect It has been found that portfolios of “low P/E” stocks generally

outperform portfolios of “high P/E” stocks. This may be related to the size effect since there is a high

correlation between the stock price and the P/E. It may be that buying low P/E stocks is essentially the same as

buying small company stocks.

Summary of Tests of the EMH  Weak form is supported, so technical analysis cannot consistently

outperform the market.  Semi-strong form is mostly supported , so fundamental analysis cannot

consistently outperform the market.  Strong form is generally not supported. If you have secret (“insider”)

information, you CAN use it to earn excess returns on a consistent basis.  Ultimately, most believe that the market is very efficient, though not

perfectly efficient.

It is unlikely that any system of analysis could

consistently and significantly beat the market (adjusted for costs and risk) over the long run.