Efficient Markets Hypothesis: Theory, Evidence, and Implications for Investing, Slides of Banking and Finance

Download Efficient Markets Hypothesis: Theory, Evidence, and Implications for Investing and more Slides Banking and Finance in PDF only on Docsity! 1 BS2551 Money Banking and Finance Efficient Markets Hypothesis: Theory and Evidence 1. INTRODUCTION Schleifer (2000) argues, the existence of arbitrage opportunities is a necessary condition that can lead to market efficiency. The origins of the Efficient Markets Hypothesis (EMH) can be traced back to the pioneering theoretical contribution of Louis Bachelier (1900). Bachelier in his remarkable doctoral thesis “La Théorie de La Spéculation” proposed the random walk as the fundamental model for financial asset prices many decades before the idea became widely accepted by other academics. Samuelson (1965) initiated the modern literature by proving that asset prices in efficient markets fluctuate randomly, and only in response to new information. In this lecture we will analyse the EMH, its implications for investing, and the relevant empirical evidence. Docsity.com 2 2. EMH versus operational & allocational efficiency It should be stressed that the EMH deals with the information processing efficiency of financial markets, and not with the standard economic notions of allocational and operational efficiency. An allocationally efficient market is one where prices are determined in a way that equates the marginal rates of return (adjusted for risk) for all producers and savers. In such a market, scarce savings are optimally allocated to productive investments in a way that benefits everyone. Operational efficiency deals with the cost of transferring funds. In the theoretical world of perfect capital markets, transaction costs are assumed to be zero and markets are perfectly liquid, implying perfect operational efficiency. Market efficiency is less restrictive than the notion of perfect capital markets: in an efficient market, prices fully and instantaneously reflect all available relevant information. In Docsity.com 5 RANDOM WALK 90 95 100 105 110 115 120 1 8 15 22 29 36 43 50 57 64 71 78 85 92 99 106 113 120 127 134 141 148 As Kortian (1995) argues, there are several aspects of modern asset markets trading, which are clearly contrary to the sort of behavior implied by the weak-form efficiency. For instance, the frequent employment of stop-loss orders (selling orders which are activated once the asset price has fallen by a particular pre-determined amount), and the development of dynamic hedging strategies, such as portfolio insurance, according to which, investors buy in a rising market and sell into a falling one. Such strategies base investment decisions on past asset price movements. Their presence is also consistent with the view that investors can often behave in a destabilising Docsity.com 6 manner, moving the asset price away from its intrinsic (fundamental) value rather than towards it. (ii) Semistrong-form efficiency: No investor can earn excess returns from trading rules based on any publicly available information. Examples of publicly available information are annual reports and financial statements of companies, reports in the financial press, and historical data. Semistrong-form efficiency implies that all publicly available information is fully reflected in the actual asset price. With semistrong efficiency, the market’s reaction to new relevant information should be instantaneous and unbiased, without any systematic pattern of under or overreaction. It also implies that fundamental analysis, based on using public financial information, shouldn’t produce abnormal returns. Docsity.com 7 (ii) Strong-form efficiency: No investor can earn excess returns using any information, whether publicly available or private information. Strong-form efficiency implies that all information is fully reflected in the actual asset price. The strong-form efficiency is very strong indeed! It implies that corporate insiders cannot profit using private information. For example, suppose that we know that our firm has just made an important technological discovery. Strong-form efficiency implies that prices will have adjusted (so that no profit) before we even had a chance to trade upon the news. Days before and after announcement Stock price 0 Efficient-market response to new information Overreaction and reversion Docsity.com