Corporate Finance

Lecture 11

Corporate Finance

Lecture 11 :
Efficient Market Theory

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Efficient Market Theory

! Three types of efficiency
!

Allocational efficiency
Ability of the market to allocate financial resources
among the economic units

Operational efficiency
Ability of the market to carry out the buy-sell
transactions smoothly

Pricing efficiency
Ability of the market to price securities fairly & quickly
in response to available information
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Corporate Finance

Lecture 11

Efficient Market Theory

! A market is said to be efficient if investors cannot make
excess returns through the use of trading rules or strategies
based on a certain given information
! Excess returns refer to the level of return after costs & above
appropriately adjusted for risk

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Efficient Market Theory

! Conditions for Efficient Market Theory
! Free entry / exit for investors
! No prohibiting transaction costs
! No individual dominates market
! Investors are rational in maximising utility & responding to
information
! Investors have equal access to information
! Information efficiency ie. Speed at which information
become available

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Corporate Finance

Lecture 11

Forms of Efficiency
! Weak Form Efficiency
! Prices in market incorporates all relevant historical &
publicly announced information
! Prices change whenever new information is announced
! Changes in price occur randomly since information arrives
unexpectedly -> Market tends to be more volatile
=> Proves validity of Random Walk Theory (RWT) &
invalidates Chartist Analysis Theory (CAT) in predicting
future price movements
! To make excess returns, investors need unannounced
anticipative information
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Forms of Efficiency
! Semi-Strong Form Efficiency
! Prices in market incorporates all relevant historical &
publicly anticipative information whether announced or
not
! Prices change when unexpected information is announced
=> Market becomes more stable
! To make excess returns, investors need insider
information

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Corporate Finance

Lecture 11

Forms of Efficiency
! Strong Form Efficiency
!

Prices in market incorporates all relevant information

including insider information

Impossible to make excess returns

To maximise wealth of shareholders, management only

need to maximise return on all its investments
If fundamentals improve then shares prices will increase

Consistent with Fundamental Analysis Theory (FAT)

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Forms of Efficiency
! Efficient Market Theory relates to the responsiveness of
market to information & not efficiency in obtaining
information
! However, if information is speedily available then if a
financial market is efficient, prices of security will respond
earlier
! It is concerned with the ability to make excess returns based
on a certain information set ie.
! Historical & publicly announced information set
! Anticipative information set
! Insider information set
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Corporate Finance

Lecture 11

Forms of Efficiency
! To test such informational efficiency, one needs a technique
for calculating risk-adjusted returns, which can be formulated
as follows :

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Forms of Efficiency
! Joint Hypothesis Problem associated with testing market
efficiency
! If excess returns are achieved, it would suggest that
markets are not efficient with respect to the information
set that was tested
! However, this will be misleading if in fact the markets are
efficient but an incorrect model or risk-adjustment
technique was used in determining the expected returns
=> Not sure whether
1) Markets are inefficient or
2) Model for expected returns is wrong
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Corporate Finance

Lecture 11

Forms of Efficiency
!

Null hypothesis for the testing market efficiency comprises

of 2 components :
Informational efficiency
Accuracy of the model for expected return calculations

Rejection (acceptance) of the null hypothesis is not

conclusive that the market is inefficient (efficient)!

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Weak Form Efficiency : Implications &

Tests
! Current & past asset returns should have no predictive power
for future returns on those assets
! Statistically, this can be expressed as :

=> Asset returns are uncorrelated with their own past

values

Form the basis for the test of weak form efficiency

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Corporate Finance

Lecture 11

Weak Form Efficiency : Implications &

Tests
! Prices of any asset are as predicted by the Random Walk
Model :

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Weak Form Efficiency : Empirical Results

! Calendar Effects Anomalies
! Hours of the day
1st 45 minutes of Mondays -> Negative
1st 45 minutes of other weekdays -> Positive
1st 45 minutes after lunch -> Negative
! Day of the week
Friday : Consolidation i.e. evaluate & make sell
decisions
Monday : Sell decisions carried out
Wednesday : Consistently highest return in the week
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Corporate Finance

Lecture 11

Weak Form Efficiency : Empirical Results

!

Month of the year

Tax Loss Selling Hypothesis
UK : Mar (Sell) - Apr (Buy)
US : Dec (Sell) - Jan (Buy)
Not applicable in Singapore as there is no capital gain tax
However we have Capricorn Effect in Dec - Jan & CPF
Effect where investors can sell & take out their profits
Recent (2005) research shown weakening of the
Capricorn effect in Singapore
Incredible Jan effect : Stock returns are statistically
positive & greater in January than in any other month
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Weak Form Efficiency : Empirical Results

! Test of return autocorrelation
! Autocorrelation refers to a property displayed by some
sequences of adjacent items not being independent of each
other
! Weak form efficiency implies that all autocorrelations of
returns should be statistically indistinguishable from zero
ie. Next period return cannot be predicted by this periods
return
! Corrective behavior of share prices i.e. good & poor
return on a particular share alternate from year to year
would suggest that the market is not weak form as excess
returns are possible to achieve
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Corporate Finance

Lecture 11

Weak Form Efficiency : Empirical Results

!

Daily & weekly (ie. Short horizon) returns demonstrated

positive autocorrelation

Autocorrelation evidence is reversed when one looks at

very long horizons
Fama & French (1988) shows that portfolio returns
measures over 3 to 5 years demonstrate negative
autocorrelation

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Weak Form Efficiency : Empirical Results

!

Findings of short-term (daily & weekly) autocorrelation is

not conclusive that the market is informational inefficient
as test (by Lo & MacKinlay 1988) has shown that the
strength of the autocorrelation is dependent on the size of
the stock
=> Size anomalies
Size anomalies
Positive return autocorrelation for small stocks >
Positive return autocorrelation for large stocks
Possible reasons :
Infrequent trading of small stocks
Non-synchronous trading of small stocks
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Corporate Finance

Lecture 11

Weak Form Efficiency : Empirical Results

!

For long-term autocorrelation evidence, the presence of

mean reversion in expected returns over time
=> Inconclusive finding of inefficient market

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Weak Form Efficiency : Empirical Results

! Impact of other variables on stock returns
! Fundamental analysis
[by Lakonishok, Shleifer & Vishny (LSV) 1994]
Focuses on share prices relative to their fundamentals
Value (low price to fundamentals) vs Glamour (high
price to fundamentals) stocks
Results from 5 years performance tracking
Portfolios average price to fundamental at the
point of allocation -> Portfolios subsequent
returns ie.
=> Value portfolio outperforms glamour portfolio
Contrarian strategy : Buying losers & short-selling
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Corporate Finance

Lecture 11

Weak Form Efficiency : Empirical Results

!

Technical analysis : To generate trading signals

(by DeBondt & Thaler 1985)
Allocate stocks based on past performance measured by
excess returns in prior years
Losers vs winners stocks
Findings over the 3 years following the allocation of the
portfolios are as follows :
Losers outperformed the winners
Excess returns tend to take place in January
=> January effects
Contrarian strategy : Buying losers & short-selling
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Weak Form Efficiency : Empirical Results

!

To be consistent with EMH, the portfolio with higher

return can only be explained through higher risk
From conventional risk measures such as & , value
portfolio is quite risky BUT not high enough to justify the
observed differences in subsequent portfolio returns
LSV found that the glamour stocks were not able to
maintain the earnings growth rate
Actual earnings growth rate > Expected earnings
growth rate implicit in stock prices BUT only validated
for 1 - 2 years
=> High earnings growth of glamour stocks does not
persist!
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Corporate Finance

Lecture 11

Weak Form Efficiency : Empirical Results

!

Possible explanations for the findings

Investors pursue nave investment strategies
Treat well-run companies as good investment
Extrapolating trends : Using technical trading rules
Overreacting : Overreact to unexpected events
Higher returns due to higher risk
=> Higher returns are not excess returns
Fama & French (1992)
Fundamentally Higher Risk -> Return -> Compensate
investors for taking higher risk
Not conclusive of market inefficiency
=> Joint hypothesis problem
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Weak Form Efficiency : Empirical Results

! Technical trading rule applications
!

Moving average crossover : If a shorter period moving

average chart cuts a longer period moving average chart
from below upwards (above downwards), it presents strong
buying (selling) signal
Can lead to positive excess returns generated
Existence of positive excess return using trading rules does
not support weak form market efficiency as it suggests that
Prices can be predicted
History will repeat itself
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Corporate Finance

Lecture 11

Semi-Strong Form Efficiency :

Implications & Tests
! Event study is the primary empirical methodology used for
examining semi-strong form of market efficiency
! Methodology
1) Identify a hypothetical situation to study (e.g.
earnings announcement)
2) Select a sample of relevant firms
3) Collect ex-ante expectation of earnings
4) Determine period of event study (e.g. dates)
5) Construct average abnormal returns for each date

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Semi-Strong Form Efficiency :

Implications & Tests
CAR

CAR

Date

Markets are efficient

Date

Markets are inefficient

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Corporate Finance

Lecture 11

Semi-Strong Form Efficiency :

Empirical Evidence
! Results are generally encouraging for believers in the
informational efficiency of markets
! New information is quickly & accurately reflected in the
prices

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Strong-Form Efficiency
! Least information available for testing of this form of market
efficiency
! Certain Empirical Studies
! Whether corporate insiders make gain from trading on their
own companys stock?
Insider (such as directors & major shareholders) trades
can generally be used to predict stock price changes
suggesting that markets are not strong form efficient

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Corporate Finance

Lecture 11

Strong-Form Efficiency
!

Information on the forecasts of professional analysts &

surveys?
Existence of private information in the hands of
professional & privileged agents could result in
abnormal returns

Mutual fund performance

Funds under-performed the market by about 2% p.a.

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Equitability vs Capitalism
! To achieve total equitability, market needs a strong form of
efficiency BUT this will stifle a market driven & capitalistic
economy
! Companies need some degree of confidentiality to maintain
their niches & succeed
! To strike a balance, Government has strong legislation against
insider trading

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Corporate Finance

Lecture 11

Investments & EMT

! EMT & the investor / analyst
! Race to have quicker access to information resulting in the
importance of good research in stockbroking firm
! The more research is emphasized, the more efficient the
market becomes ie. the quicker information becomes priced
in
! Share prices can be trusted
Investors rarely beats the system
No bargain hunting

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Investments & EMT

!

To earn above average return, investors need

To take higher risk
Low transaction costs
LUCK
2 other possible ways
Insider information
New analysis or insight to market

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Corporate Finance

Lecture 11

Investments & EMT

! Importance of timing of purchase & sale
! Recognising turning points in the market which has high
correlation with economy
! Capitalising on short term overreactions
! Only enables investors to know when to buy & sell NOT
what to buy & sell

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Investments & EMT

! EMT & company financing decisions
! Timing of share issue
Tie in with release of new information depending on
whether information is adverse or favorable
BUT if shareholders pay high price, they expect high
return which may be difficult for management to ensure
Hence, waste of time to catch the market

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Corporate Finance

Lecture 11

Investments & EMT

! Sale of large block of shares
! Concern : Increase in supply
! Argument : If market is efficient & large enough & is
convinced that new funds will earn at least same return as
existing funds THEN demand will correspondingly
increase & price maintained
! Acquisitions
! On average, unlikely to have a bargain i.e. acquiring
company may not have access to all relevant information

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Conclusion of EMT
! Market is generally efficient, at least weak form BUT tending
to semi strong depending on how much competition in
obtaining information
! Most times prices are fair & returns commensurate with risk
level BUT some times there are weak moments which can be
exploited either on a market, sector & individual share basis

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Corporate Finance

Lecture 11

Grossman-Stiglitz Paradox
! A full aggregating market is when prices reflect all
information, otherwise it is known as averaging prices
! In a market, there are two types of traders
!

Informed traders

Uninformed traders

! Informed traders gather information & acquire better

estimates of future states of nature
=> They take positions based on the information they
gathered

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Grossman-Stiglitz Paradox
! Uniformed traders do not spend any resources in collecting
information
=> They infer the information of informed traders by
observing the prices in the market
! Market aggregates information from both the informed &
uninformed traders so that all traders become informed
! A full aggregating market would be consistent with Famas
definition of strong-form market efficiency
=> Even investors with insider information would not be able
to profit from it
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Corporate Finance

Lecture 11

Grossman-Stiglitz Paradox
! If market is informed, then there will be no incentive to
acquire information which will result in inefficient pricing of
securities in the market
=> Market will be inefficient! (Paradox)
! To solve this paradox is to assume that the market is never
100% efficient (absence of strong-form efficiency)
! Benefits & incentives from research & analysis which will
encourage investors & analysts to continue allocating
resources to gather information
! With strong-form market efficiency in a market, random
selection of securities will be just as effective
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