Chapter 9

The Capital Markets and Market Efficiency

Prof. Rushen Chahal

Prof. Rushen Chahal

The notion that science, left to itself, is bound to evolve more and more of the truth about the world is another illusion, for science can never exist outside a society, and that society, whether deliberately or unconsciously, directs its course. - Northrop Frye

Prof. Rushen Chahal

Outline
Introduction Role of the capital markets Efficient market hypothesis Anomalies

Prof. Rushen Chahal

Introduction
Capital market theory springs from the notion that:
People like return People do not like risk Dispersion around expected return is a reasonable measure of risk

Prof. Rushen Chahal

Role of the Capital Markets

Definition Economic function Continuous pricing function Fair price function

Prof. Rushen Chahal

Definition
Capital markets trade securities with lives of more than one year Examples of capital markets
New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Chicago Board of Trade Chicago Board Options Exchange (CBOE)

Prof. Rushen Chahal

Economic Function
The economic function of capital markets facilitates the transfer of money from savers to borrowers
E.g., mortgages, Treasury bonds, corporate stocks and bonds

Prof. Rushen Chahal

Continuous Pricing Function

The continuous pricing function of capital markets means prices are available moment by moment
Continuous prices are an advantage to investors Investors are less confident in their ability to get a quick quotation for securities that do not trade often

Prof. Rushen Chahal

Fair Price Function

The fair price function of capital markets means that an investor can trust the financial system
The function removes the fear of buying or selling at an unreasonable price The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

Prof. Rushen Chahal

Efficient Market Hypothesis

Definition Types of efficiency Weak form Semi-strong form Strong form Semi-efficient market hypothesis Security prices and random walks
Prof. Rushen Chahal 10

Definition
The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair
The EMH is perhaps the most important paradigm in finance

Prof. Rushen Chahal

11

Types of Efficiency
Operational efficiency measures how well things function in terms of speed of execution and accuracy
It is a function of the number of order that are lost or filled incorrectly It is a function of the elapsed time between the receipt of an order and its execution

Prof. Rushen Chahal

12

Types of Efficiency (cont d)

Informational efficiency is a measure of how quickly and accurately the market reacts to new information
It relates directly to the EMH The market is informationally very efficient
Security prices adjust rapidly and accurately to new information The market is still not completely efficient

Prof. Rushen Chahal

13

Weak Form
Definition Charting Runs test

Prof. Rushen Chahal

14

Definition
The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past
The current price is a fair one that considers any information contained in the past price data Charting techniques or of no use in predicting stock prices

Prof. Rushen Chahal

15

Definition (cont d)
Example
Which stock is a better buy?
Stock A Current Stock Price Stock B

Prof. Rushen Chahal

16

Definition (cont d)
Example (cont d)
Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

Prof. Rushen Chahal

17

Charting
People who study charts are technical analysts or chartists
Chartists look for patterns in a sequence of stock prices Many chartists have a behavioral element

Prof. Rushen Chahal

18

Runs Test
A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance
A run is an uninterrupted sequence of the same observation A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number

Prof. Rushen Chahal

19

Conducting A Runs Test

Rx Z! W where R ! number of runs 2n1n2 x! 1 n1  n2 W! 2n1n2 (2n1n2  n1  n2 )

n1  n2

(n1  n2  1)

n1 , n2 ! number of observations in each category Z ! standard normal variable

Prof. Rushen Chahal 20

Semi-Strong Form
The semi-strong form of the EMH states that security prices fully reflect all publicly available information
E.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

Prof. Rushen Chahal

21

Semi-Strong Form (cont d)

Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as:
Stock splits Cash dividends Stock dividends

This means investor are seldom going to beat the market by analyzing public news

Prof. Rushen Chahal

22

Strong Form
The strong form of the EMH states that security prices fully reflect all public and private information This means even corporate insiders cannot make abnormal profits by using inside information
Inside information is information not available to the general public

Prof. Rushen Chahal

23

Semi-Efficient Market Hypothesis

The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others
Less well-known companies are less efficiently priced The market may be tiered A security pecking order may exist

Prof. Rushen Chahal

24

Security Prices and Random Walks

The unexpected portion of news follows a random walk
News arrives randomly and security prices adjust to the arrival of the news
We cannot forecast specifics of the news very accurately

Prof. Rushen Chahal

25

Anomalies
Definition Low PE effect Low-priced stocks Small firm effect Neglected firm effect Market overreaction January effect
Prof. Rushen Chahal 26

Anomalies (cont d)
Day-of-the-week effect Turn-of-the calendar effect Persistence of technical analysis Chaos theory

Prof. Rushen Chahal

27

Definition
A financial anomaly refers to unexplained results that deviate from those expected under finance theory
Especially those related to the efficient market hypothesis

Prof. Rushen Chahal

28

Low PE Effect
Stocks with low PE ratios provide higher returns than stocks with higher PEs Supported by several academic studies Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

Prof. Rushen Chahal

29

Low-Priced Stocks
Stocks with a low stock price earn higher returns than stocks with a high stock price There is an optimum trading range Every stock with a high stock price should split

Prof. Rushen Chahal

30

Small Firm Effect

Investing in firms with low market capitalization will provide superior riskadjusted returns Supported by academic studies Implies that portfolio managers should give small firms particular attention
Prof. Rushen Chahal 31

Neglected Firm Effect

Security analysts do not pay as much attention to firms that are unlikely portfolio candidates Implies that neglected firms may offer superior risk-adjusted returns

Prof. Rushen Chahal

32

Market Overreaction
The tendency for the market to overreact to extreme news
Investors may be able to predict systematic price reversals

Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

Prof. Rushen Chahal

33

January Effect
Stock returns are inexplicably high in January Small firms do better than large firms early in the year Especially pronounced for the first five trading days in January

Prof. Rushen Chahal

34

January Effect (cont d)

Possible explanations:
Tax-loss trading late in December (Branch) The risk of small stocks is higher early in the year (Rogalski and Tinic)

Prof. Rushen Chahal

35

Types of Firms in January

January return S&P 500 Companies Highly Researched Moderately Researched Neglected Non-S&P 500 Companies Neglected 11.32% 10.72%
Prof. Rushen Chahal

January return minus average monthly return in rest of year

January return after adjusting for systematic risk

2.48% 4.95% 7.62%

1.63% 4.19% 6.87%

-1.44% 1.69% 5.03%

7.71%
36

Day-of-the-Week Effect
Mondays are historically bad days for the stock market Wednesday and Fridays are consistently good Tuesdays and Thursdays are a mixed bag

Prof. Rushen Chahal

37

Day-of-the-Week Effect (cont d)

Should not occur in an efficient market
Once a profitable trading opportunity is identified, it should disappear

The day-of-the-week effect continues to persist

Prof. Rushen Chahal

38

Turn-of-the-Calendar Effect
The bulk of returns comes from the last trading day of the month and the first few days of the following month For the rest of the month, the ups and downs approximately cancel out

Prof. Rushen Chahal

39

Persistence of Technical Analysis

Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices Studies show the markets are efficient in the weak form Literature based on technical techniques continues to appear but should be useless

Prof. Rushen Chahal

40

Chaos Theory
Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic Econophysics refers to the application of physics principles in the analysis of stock market behavior
E.g., an investment strategy based on studies of turbulence in wind tunnels

Prof. Rushen Chahal

41