Chapter 3
Introduction
to
Corporate Finance
Efficient
Market
Hypothesis
2
Chapter Outline
• Random Walk Theory
• Efficient Market Hypothesis
• Levels of Efficiency
The Weak Form
The Semi-strong Form
The Strong Form
• The Lesson Learnt
• Market Imperfection
• Behavioural Finance
• Implication to Corporate Finance
• Challenges
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3
The Random Walk
Random price
movements
Price moves at
give no
random and Random
advantage to
cannot be
any particular
predicted.
trading Walk means
strategy. the price
today is
unrelated to
yesterday’s
Contradicts the Have a serious
entire concept implication on price, hence
of technical corporate not
analysis. finance.
predictable
from past
prices
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4
Efficient Market Hypothesis
An efficient market is the market
where information is rapidly and
accurately incorporated into share
prices.
According to Fama (1970), a
financial market is efficient if prices
always fully reflect available
information.
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Share Price Reaction to New 5
Information
Market
Efficiency
Direction Magnitude Speed
Quality of Quality of Time-lapse to
price price incorporate
formation formation information
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Reaction of Stock Price to New Information in Efficient and
Inefficient Markets (Good News)
Overreaction to “good news”
with reversion
Slow/Delayed
response to “good
news”
Efficient market response
New information is leaked and
to “good news price respond before public
dissemination
-30 -20 -10 0 +10 +20 +30
Public Announcement date
Chapter 4- Efficient Market Hypothesis 6
Reaction of Stock Price to New Information in Efficient and
Inefficient Markets (Bad News)
Slow/Delayed
response to
Efficient market response to “bad “bad news”
Stock news
Price
-30 -20 -10 0 +10 +20 +30
Overreaction to “bad news” with Days before (-) and after (+)
reversion announcement
Chapter 4- Efficient Market Hypothesis 7
8
Share Price Reaction to New
Information (cont.)
where,
A is efficient market response
to new information.
B is delayed response.
C is overreaction and
reversion.
D is the equilibrium price.
E is leak in new information.
Price respond before public
dissemination.
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9
Efficient Market Hypothesis
In an efficient market, prices respond
instantaneously to new information and fully
reflect that information.
After the public announcement date, no further
changes in the stock price.
The delayed response usually takes 30-days to
fully absorb the information.
Delayed response/Leak information (under-
reaction and over-reaction) to new information
would suggest that the market is inefficient.
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10
Features of efficient market
None of them alone
can affect the prices
of any security
Many knowledgeable
investors actively
analyzing, valuing, and Information is widely
trading. available and nearly free
Investor reacts quickly
Information on firm and accurately to new
unique events like labor information
strike, changes in
product demand, and so
on tends to emerge
randomly Prices will adjust
quickly and on
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reserved.
11
Levels of Market Efficiency
The Weak Form
• share prices fully incorporate all historical financial share
price movements
The Semi-strong Form
• prices reflect all relevant information about past price
movements and publicly available knowledge. This form of
the market shows that share prices reflect both:
All relevant information about past price movements
All publicly available information
The Strong Form
• prices reflect all relevant information about past price
movements, publicly available knowledge, and inside
knowledge and thus, there is no such thing as secret.
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12
Weak Form Efficiency
Security prices reflect all information found in past prices and volume.
If the weak form of market efficiency holds, then technical analysis has no
value. (because historical prices information is the easiest kind of information about the
stock to acquire already reflected in the stock price)
Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t
Price today is equal to the sum of the last observed price plus the expected
return on the stock plus a random component is due to new information on
stock.
Since stock prices only respond to new information (could be either positive or
negative), stock prices are said to follow a random walk.
The expected return is a function of a security’s risk and would be based on the
models of risk and return.
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13
Test Weak Form Efficiency
Use serial correlation to find the correlation between the current
return on security and the return on the same security over a later
period.
The correlation will indicate whether a relationship between
yesterday’s returns and today’s returns does exist.
A positive coefficient of serial correlation for a particular stock
indicates tendency towards continuation. (if yesterday’s return higher,
today’s return also higher)
A negative coefficient indicates a tendency towards reversal. (if
yesterday’s return is higher, today’s return will be lower)
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14
Test Weak Form Efficiency
The significant positive and negative serial correlation are indications of
the market being inefficient; return today can be used to predict
future return.
Why? It is cheap and easy to find patterns in stock prices
Serial correlation coefficients for stock returns near zero would be
consistent with the random walk hypothesis which is strongly consistent
with weak-form efficiency.
Findings from previous tests showed a very low correlation coefficients.
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15
Semi-Strong Form Efficiency
Stock prices reflect all publicly
available information. Uses more
sophisticated information and reasoning
than weak-form efficiency.
It implies that most fundamental
analysis is useless.
Publicly available information includes:
Historical price and volume information
Published accounting statements.
Information found in annual reports.
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16
Test Semi-Strong Form Efficiency
Use Event Studies methodology:
Stock Splits
Dividend increases and decreases
Mergers
Capital Spending
New Issue of Stock
Earnings Announcement
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17
Test Semi-Strong Form Efficiency
The studies support the view that the market is semi-strong-from
efficient. In fact, the studies suggest that news tends to leak out in
advance of public announcement.
Use Event Studies – Stock Split - examine the following relationship:
Information released at time t – 1↔ AR t-1
Information released at time t ↔ AR t
Information released at time t+1↔ AR t+1 AR = Abnormal
Return
Indicate that the return in any time period is related only to the
information released during that period.
A stock split is when a company increases the number of its outstanding shares to boost
the stock's liquidity to lower the price of a single share, making the company's stock more
affordable without losing value. But the total dollar value of all shares outstanding
remains the same because a split does not fundamentally change the company's value.
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Event Studies: Dividend Omissions (no dividend)
Cumulative Abnormal Returns for Companies Announcing Dividend
Omissions
Cumulative abnormal returns (%)
0.146 0.108 0.032 0
-8 -6 -4 -0.244
-2 -0.483 0 2 4 6 8
-0.72
-1
-2
-3
-3.619
-4
-4.563 -4.49
-4.898 -4.747 -4.685
-5 -5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
Chapter 4- Efficient Market Hypothesis 18
19
Test Semi-Strong Form Efficiency
Record of Mutual Funds
If the market is semi-strong-form efficient, then the
average returns PFM should be the same as those of
the average investor in the market because both rely
on publicly available information to pick stocks,
We can test efficiency by comparing the performance
of professionally managed mutual funds with the
performance of a market index.
Findings: Professional fund manager (PFM) does not
outperform the market index. Therefore, it is
consistent with semi-strong and weak form efficiency.
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20
Strong Form Efficiency
Security Prices reflect all information - past,
public and private. Strong form efficiency
incorporates weak and semi-strong form
efficiency.
If the market is strong form efficiency, no
investor can beat the market or make
abnormal returns consistently by having inside
information.
There are no such things as secrets
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Strong Form Efficiency – Inside 21
Information
These are information possessed by
people in special position inside the
company @ insider trading.
An investor can profit from inside
information
Good news – invest in the stock
Bad news - sell the stocks
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22
Test Strong Form Efficiency
One group of studies of
strong-form market efficiency
investigates insider trading.
Few studies support the view
that insider trading is
abnormally profitable.
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23
Lesson
Learnt
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24
Market Imperfection
Calendar Effect
Small-firm Effect
Earnings Announcement
Price Earnings Effect
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Market Imperfection – Pricing Anomalies25
Temporal Anomalies @ Calendar Effect:
Average stock returns in January are higher than in other
months for both large and small capitalization securities.
Stock returns are highest on Wednesdays and Fridays and
lowest on Mondays.
Average stock returns in the US have been negative on
Mondays. (Monday Effect or Monday Blues)
Average stock returns are significantly higher over the first half
of the month than over the second half of the month.
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26
Behavioral Finance
Overconfidence
Biased Self-attribution
Loss Aversion
Representativeness
Narrow Framing
Belief Perseverance
Conservatism
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27
Implications on Corporate Finance
If the market is in strong-form efficiency, the managers need to
concentrate only on maximizing the net present value of an
investment to maximize shareholders’ wealth
Managers do not have to identify the correct timing for issuance of
shares.
Market can always identify any attempts on window dressing the
accounts.
Market will decide on the most appropriate level of returns it requires
that commensurate the risk of making the investment.
It is a waste of time for manager to look for takeover targets
companies whose shares are undervalued for expansion strategy since
the share
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28
Challenges
Forming a
strategy by
buying the losing
Past research
stocks and Evidence of stock
documented
simultaneously market bubbles
evidence of
selling the and crashes also
predictability in
winning stocks violates the EMH
stock returns.
may generate
abnormal
returns.
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29
Stock Market Bubbles and Crashes
A stock market bubble occurs when the price of a stock or asset rises
exponentially over time @ hit a ceiling, much above its intrinsic value, and
then plummets dramatically
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