Efficient Market Theory

Lecture Outline
1. Can Financing Decisions Create Value?
2. A Description of Efficient Capital Markets
3. The Different Types of Efficiency
4. The Evidence
5. Implications for Corporate Finance
6. Summary and Conclusions
 How to Create Value through
Financing
1. Fool Investors
 Empirical evidence suggests that it is hard to fool investors
consistently.

2. Reduce Costs or Increase Subsidies

 Certain forms of financing have tax advantages or carry other
subsidies.

3. Create a New Security

 Sometimes a firm can find a previously-unsatisfied clientele
and issue new securities at favorable prices.
 In the long-run, this value creation is relatively small,
however.
 A Description of Efficient Capital Markets

• An efficient capital market is one in which stock

prices fully reflect available information.
• The EMH has implications for investors and firms.
– Since information is reflected in security prices
quickly, knowing information when it is released does
an investor no good.
– Firms should expect to receive the fair value for
securities that they sell. Firms cannot profit from
fooling investors in an efficient market.
 Reaction of Stock Price to New
Information in Efficient and Inefficient
Markets
Stock
Price Overreaction to “good
news” with reversion

Delayed
response to
“good news”
Efficient market
response to “good news”

-30 -20 -10 0 +10 +20 +30

Days before (-) and
after (+)
announcement
Reaction of Stock Price to New Information
in Efficient and Inefficient Markets
Stock Efficient market
response to “bad news” Delayed
Price response to
“bad news”

-30 -20 -10 0 +10 +20 +30

Overreaction to “bad Days before (-) and
news” with reversion after (+)
announcement
 The Different Types of Efficiency
• Weak Form
– Security prices reflect all information found in past
prices and volume.
• Semi-Strong Form
– Security prices reflect all publicly available
information.
• Strong Form
– Security prices reflect all information—public and
private.
Weak Form Market Efficiency
• Security prices reflect all information found in
past prices and volume.
• If the weak form of market efficiency holds,
then technical analysis is of no value.
• Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t
• Since stock prices only respond to new
information, which by definition arrives
randomly, stock prices are said to follow a
random walk.
 Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price

If it were possible to make

Sell
big money simply by
Sell finding “the pattern” in the
stock price movements,
Buy everyone would do it and
Buy the profits would be
competed away.

Time
Semi-Strong Form Market Efficiency
• Security Prices reflect all publicly available
information.
• Publicly available information includes:
– Historical price and volume information
– Published accounting statements.
– Information found in annual reports.
Strong Form Market Efficiency
• Security Prices reflect all information—public
and private.
• Strong form efficiency incorporates weak and
semi-strong form efficiency.
• Strong form efficiency says that anything
pertinent to the stock and known to at least
one investor is already incorporated into the
security’s price.
Relationship among Three Different
Information Sets
All information
relevant to a stock

Information set
of publicly available
information

Information
set of
past prices
 Some Common Misconceptions
• Much of the criticism of the EMH has been
based on a misunderstanding of the
hypothesis says and does not say.
 What the EMH Does and Does NOT
Say
• Investors can throw darts to select stocks.
– This is almost, but not quite, true.
– An investor must still decide how risky a portfolio he
wants based on risk aversion and the level of
expected return.
• Prices are random or uncaused.
– Prices reflect information.
– The price CHANGE is driven by new information,
which by definition arrives randomly.
– Therefore, financial managers cannot “time” stock
and bond sales.
 The Evidence
• The record on the EMH is extensive, and in
large measure it is reassuring to advocates
of the efficiency of markets.
• Studies fall into three broad categories:
1. Are changes in stock prices random? Are there
profitable “trading rules”?
2. Event studies: does the market quickly and
accurately respond to new information?
3. The record of professionally managed
investment firms.
Are Changes in Stock Prices Random?

• Can we really tell?

– Many psychologists and statisticians believe that
most people want to see patterns even when
faced with pure randomness.
– People claiming to see patterns in stock price
movements are probably seeing optical illusions.
• A matter of degree
– Even if we can spot patterns, we need to have
returns that beat our transactions costs.
• Random stock price changes support weak-
form efficiency.
 Event Studies: How Tests Are
Structured
 Event Studies are one type of test of the semi-
strong form of market efficiency.
 This form of the EMH implies that prices should
reflect all publicly available information.
 To test this, event studies examine prices and
returns over time—particularly around the arrival
of new information.
 Test for evidence of under reaction, overreaction,
early reaction, delayed reaction around the
event.
 How Tests Are Structured (cont.)
• Returns are adjusted to determine if they are
abnormal by taking into account what the rest of
the market did that day.
• The Abnormal Return on a given stock for a
particular day can be calculated by subtracting
the market’s return on the same day (RM) from
the actual return (R) on the stock for that day:
AR= R – RM
• The abnormal return can be calculated using the
Market Model approach:
AR= R – ( + RM)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Cumulative abnormal returns

Dividend Omissions

0.146 0.108 0.032 0

(%)

-0.244
-8 -6 -4
-0.72 -2 -0.483 0 2 4 6 8
-1
Efficient market
-2
response to “bad news”
-3
-3.619
-4
-4.563-4.747-4.685-4.49
-5 -5.015 -4.898
-5.183
-5.411
-6

Days relative to announcement of dividend omission

S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal
of Investing (Spring 1997)
 Event Study Results
• Over the years, event study methodology has
been applied to a large number of events
including:
– Dividend increases and decreases
– Earnings announcements
– Mergers
– Capital Spending
– New Issues of Stock
• The studies generally support the view that
the market is semistrong-from efficient.
• In fact, the studies suggest that markets may
even have some foresight into the future—in
other words, news tends to leak out in
advance of public announcements.
 Issues in Examining the Results
• Magnitude Issue
• Selection Bias Issue
• Lucky Event Issue
• Possible Model Misspecification
 The Record of Mutual Funds
• If the market is semistrong-form efficient, then
no matter what publicly available information
mutual-fund managers rely on to pick stocks,
their average returns should be the same as
those of the average investor in the market as a
whole.
• We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.
 The Record of Mutual Funds
Annual Return Performance of Different Types of U.S.
Mutual Funds Relative to a Broad-Based Market Index
(1963-1998)
0.00%
Annual Return Performance

All funds Small- Other- Growth Income Growth and Maximum Sector
-10.00% company aggressive funds funds income capital funds
growth growth funds gains
funds funds funds
-20.00%

-30.00%

-40.00%

-50.00%

-60.00%
Taken from Lubos Pastor and Robert F. Stambaugh, “Evaluating and Investing in Equity Mutual Funds,” unpublished paper,
Graduate School of Business, University of Chicago (March 2000).
 The Strong Form of the EMH
• One group of studies of strong-form market
efficiency investigates insider trading.
• A number of studies support the view that
insider trading is abnormally profitable.
• Thus, strong-form efficiency does not seem to
be substantiated by the evidence.
 Views Contrary to Market Efficiency
• Stock Market Crash of 1987
– The market dropped between 20 percent and 25
percent on a Monday following a weekend during
which little surprising information was released.
• Temporal Anomalies
– Turn of the year, —month, —week.
• Speculative Bubbles
– Sometimes a crowd of investors can behave as a
single squirrel.
Implications for Corporate Finance
• Because information is reflected in security
prices quickly, investors should only expect
to obtain a normal rate of return.
– Awareness of information when it is released does an investor little
good. The price adjusts before the investor has time to act on it.

• Firms should expect to receive the fair value

for securities that they sell.
– Fair means that the price they receive for the securities they issue is
the present value.
– Thus, valuable financing opportunities that arise from fooling
investors are unavailable in efficient markets.
Implications for Corporate Finance
• The EMH has three implications for corporate
finance:
1. The price of a company’s stock cannot be affected
by a change in accounting.
2. Financial managers cannot “time” issues of stocks
and bonds using publicly available information.
3. A firm can sell as many shares of stocks or bonds as
it desires without depressing prices.
• There is conflicting empirical evidence on all
three points.
 Why Doesn’t Everybody Believe the
Efficient Market Hypothesis?
• There are optical illusions, mirages, and
apparent patterns in charts of stock market
returns.
• The truth is less interesting.
• There is some evidence against market
efficiency:
– Seasonality
– Small versus Large stocks
– Value versus growth stocks
• The tests of market efficiency are weak.
 Summary and Conclusions
• An efficient market incorporates information in
security prices.
• There are three forms of the EMH:
– Weak-Form EMH
Security prices reflect past price data.
– Semistrong-Form EMH
Security prices reflect publicly available information.
– Strong-Form EMH
Security prices reflect all information.
• There is abundant evidence for the first two
forms of the EMH.