Chapter 18 Market Efficiency

1. 1.1 1.2 Objectives Distinguish between and discuss weak form efficiency, semi-strong form efficiency and strong form efficiency. Discuss practical considerations in the valuation of shares and businesses, including: (a !undamental theory of share values (b "arketability and li#uidity of shares (c $vailability and sources of information (d "arket imperfections and pricing anomalies Describe the significance of investor speculation and the e&planations of investor decisions offered by behavioural finance.

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2. 2.1

The Efficient Market Hypothesis The Efficient Market Hypothesis )his hypothesis states that the stock market reacts immediately to all the information that is available. )hus a lon term investor cannot obtain hi her than avera e ret!rns from a well diversified share portfolio.

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Types of efficiency Operational efficiency 5 )his refers to the cost, speed and reliability of transactions in securities on the e&change. *t is desirable that the market carries o!t its operations at as lo% a cost as possible& speedily and reliably . )his may be promoted by creating as much competition between market makers and brokers as possible so that they earn only normal profits and not e&cessively high profits. #llocational efficiency 5 ,ociety has a scarcity of resources and it is important that we find mechanisms which allocate those resources to where they can be most productive. )hose industrial and commercial firms with the greatest potential to use investment funds effectively need a method to channel funds their way. ,tock markets help in the process of allocating society6s resources between competing real investments. !or e&ample, an efficient market provides vast funds for the growth of the electronics, pharmaceuticals and biotechnology industries but allocates only small amounts for slowgrowth industries. 'ricin efficiency 5 *t is the focus of this chapter, and the term efficient market hypothesis applies to this form of efficiency only. *n a pricing-efficient market the investor can e(pect to earn merely a risk)adj!sted ret!rn from an investment as prices move instantaneo!sly and in an !nbiased manner to any ne%s. +eat!res of efficient markets *t has been argued that the 9: and 9, stock markets are efficient capital markets, that is, markets in which: (a )he prices of securities bought and sold reflect all the relevant information which is available to the buyers and sellers: in other words, share prices change #uickly to reflect all new information about
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future prospects. ,o individ!al dominates the market. Transaction costs of buying and selling are not so hi h as to discourage trading significantly. *nvestors are rational. )here are lo%& or no& costs of ac-!irin information.

.mpact of efficiency on share prices *f the stock market is efficient, share prices should vary in a rational way. (a *f a company makes an investment with a positive ,'/, shareholders will get to know about it and the market price of its shares %ill rise in anticipation of future dividend increases. (b *f a company makes a bad investment shareholders will find out and so the price of its shares will fall. (c *f interest rate rise, shareholders %ill %ant a hi her ret!rn from their investments, so market prices will fall. +orms of market efficiency Three +orms of Efficiency (a 1eak form efficiency 5 9nder the weak form hypothesis of market efficiency, share prices reflect all available information abo!t past chan es in the share price. ,ince new information arrives une&pectedly, changes in share prices should occur in a random fashion. *f it is correct, then using technical analysis to study past share price movements will not ive anyone an advanta e, because the information they use to predict share prices is already reflected in the share price. 2emi)stron form efficiency 5 *f a stock market displays semistrong efficiency, current share prices reflect both: (i #ll relevant information about past price movements and their implications, and (ii $ll kno%led e which is available p!blicly. )his means that individ!als cannot 3beat the market4 by reading
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the newspapers or annual reports, since the information contained in these will be reflected in the share price. 2tron form efficiency 5 *f a stock market displays a strong form of efficiency, share prices reflect all information %hether p!blicly available or not: (i !rom past price changes (ii !rom public knowledge or anticipation (iii !rom specialists6 or e&perts6 insider knowledge (e.g. investment managers .

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Test yo!r !nderstandin 1 +hat would you believe about the efficiency of the market if you thought you could make money by: (1 insider dealing (2 analy<ing past price movements (% only by pure luck (7 analy<ing financial statements, directors6 statements, company activities, etc.=

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.mplications of efficient market hypothesis for the financial mana er *f the markets are #uite strongly efficient, the main conse#uence for financial managers will be that they simply need to concentrate on ma(imi5in the ,'/ of the company6s investments in order to ma(imi5e the %ealth of shareholders. Mana ers need not %orry, for e&ample, abo!t the effect on share prices of financial results in the published accounts because investors will make allo%ances for lo% profits or dividends in the current year if hi her profits or dividends are e(pected in the f!t!re. *f the company is looking to e&pand, the directors will be %astin their time if they seek as takeover tar ets companies whose shares are undervalued, since the market will fairly value all companies6 shares. Only if the market is semi)stron ly efficient , and the financial managers possess inside information that would si nificantly alter the price of the company6s shares if released to the market, could they perhaps gain an advantage. .owever attempts to take account of this inside information may breach insider dealing laws.
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)he different characteristics of a semi)stron form and a stron form efficient market thus affect the timin of share price movements , in cases where the relevant information becomes available to the market eventually. )he difference bet%een the t%o forms of market efficiency concerns %hen the share prices chan e, not by ho% m!ch prices eventually change. The /al!ation of 2hares The f!ndamental theory of share val!es /emember that the share values is based on the theory that the realistic market price of a share can be derived from a valuation of estimated future dividends. )he value of a share will be the discounted present value of all future e&pected dividends on the shares, discounted at the shareholders6 cost of capital. *f the f!ndamental analysis theory of share values is correct, the price of any share %ill be predictable, provided that all investors have the same information about a company6s e&pected future profits and dividends, and a known cost of capital. Chartin or technical analysis @hartists or technical analysts attempt to predict share price movements by ass!min that past price patterns %ill be repeated . )here is no real theoretical Austification for this approach, but it can at times be spectacularly successful. ,tudies have suggested that the degree of success is greater than could be e&pected merely from chance. 8andom %alk theory /andom walk theory is consistent with the fundamental theory of share values. *t accepts that a share should have an intrinsic price dependent on the fortunes of the company and the e&pectations of investors. 'ne of its underlying assumptions is that all relevant information abo!t a company is available to all potential investors who will act upon the information in a rational manner. )he key feature of random walk theory is that although share prices will have an intrinsic or fundamental value, this val!e %ill be altered as ne% information becomes available, and that the behaviour of investors is such
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that the actual share price will fluctuate from day to day around the intrinsic value. "0$ %.4 %.; Marketability and li-!idity of shares *n financial markets, li#uidity is the ease of dealing in the shares, how easily can the shares can be bought and sold without significantly moving the price= *n general, large companies, with hundreds of millions of shares in issue, and high numbers of shares changing hands ever day, have good li#uidity. *n contrast, small companies with few shares in issue and thin trading volumes, can have very poor li#uidity. )he marketability of shares in a private company, particularly a minority shareholding, is generally very limited, a conse#uence being that the price can be diffic!lt to determine. #vailability and so!rces of information *t was stated that an efficient market is one where the prices of securities bought and sold reflect all the relevant information available. -fficiency relates to ho% -!ickly and ho% acc!rately prices adj!st to ne% information. Market imperfections and pricin anomalies " $ 2arious types of anomaly appear to support the views that irrationality often drives the stock market, including the following. (a 2easonal month)of)the)year effects, day-of-the-week effects and also hour-of-the-day effects seem to occur, so that share prices might tend to rise or fall at a particular time of the year, week or day. (b )here may be a short)r!n overreaction to recent events. !or e&ample, the stock market crash in 1>3; when the market went into a free fall, losing 2?B in a few hours. (c *ndividual shares or shares in small companies may be neglected. *ehavio!ral finance 2pec!lation by investors and market sentiment is a maAor factor in the behaviour of share prices. *ehavio!ral finance is an alternative vie% to the
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efficient market hypothesis. *t attempts to e&plain the market implications of the psycholo ical factors behind investor decisions and suggests that irrational investor behavio!r may significantly affect share price movements. )hese factors may e&plain why share prices appear sometimes to over-react to past price changes.

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E(amination 2tyle :!etions :!estion 1 Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss the significance to a listed company if the stock market on which its shares are traded is shown to be semi-strong form efficient. (3 marks ($@@$ !> !inancial "anagement December 2??; C1

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