Efficient Market Theory Presentation Transcript
1.Efficient Market Theory
“Efficient market is defined as the market where there are large number of rational profit-maximisers, actively competing with each other to predict even the market value of individual securities and where current information is almost freely available to all participants.”
3.Features of Efficient Market
All instruments are correctly priced as all available information is perfectly understood and absorbed by all the investors.
No excess profits are possible.
In a perfectly efficient market, analysts immediately compete away any chance of earning abnormal profits.
The forces of demand and supply move freely and in an independent and random manner.
4.Explanation for the efficiency of the markets
The equilibrium price of the security is determined by demand and supply forcesbased in available information. Thisequilibrium price will immediately changeas fresh information becomes available.
Information must be free and quick to flow.
There are no transaction costs and bottlenecks.
Taxes do not impact investment policy.
Every investor can borrow or lend at the same rate.
Investors behave rationally.
Market prices are efficient and absorb the market information quickly and efficiently.
Future price changes will be due to new information not available earlier.
6.FORMS OF THE EFFICIENT MARKET HYPOTHESIS (EMH)
Efficient market hypothesis can be divided into three categories:
1.The weak form
2.The semi strong form, and
3.The strong form.
7.Weak form of EMH
According to weak form of EMH, current prices reflect all information which is already contained in the past. The weak form of theory is just opposite of technical analysis. In the weak form of efficiency market, the past prices do not provide help in giving any information about the future prices. The short term trader adopt ‘buy & hold’ strategy.
8.Semi strong form
The semi strong form of the efficient market hypothesis says that current prices of stocks reflect all publicly available information. In effect, the semi strong form of the efficient market hypothesis maintains that as soon as information becomes publicly available, it is absorbed and reflected in stock prices.
9.Strong form of emh
Strong form of the efficient market hypothesis maintains that security prices fully reflect all information, including both public and private information. Specifically, no information that is available be it public or insider can be used to consistently earn superior investment returns. This implies that not even security analysts and portfolio managers who have access to information more quickly than the general investing public is able to use this information earn superior returns.
10.Implications of the EMH
The key to successful technical analysis is a sluggish response of stock prices to fundamental supply and demand factors.
The efficient market hypothesis implies that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices.
An interesting question is whether a technical rule that seems to work will continue to work in the future once it becomes widely recognized. A clever analyst may occasionally uncover a profitable trading rule but the real test of efficient markets is whether the rule itself becomes reflected in stock prices once its value is discovered.
11.Implications of the EMH
Suppose, for example, the Dow Theory predicts an upward primary trend. If the theory is widely accepted, it follows that many investors will attempt to buy stocks immediately rather than at the gradual, long lived pace initially accepted. The Dow theory’s predicted trend would be replaced by a sharp jump in prices. It is in this sense that price patterns ought to be self destructing. Once a useful technical rule (or price pattern) is discovered, it ought to be invalidated when the mass of traders attempt to exploit it.
Thus, the market dynamic is one of continual search for profitable trading rules, followed by destruction by overuse of those rules found to be successful, following by more search for yet-undiscovered rules.
EMH predicts that most fundamental analysis is doomed to failure.
If analyst relies on the publicly available earnings and industry information, his or her evaluation of the firm’s prospects is not likely to be significantly more accurate than those of rival analysts.
Discovery of good firms through fundamental analysis does an investor no good if the rest of the market also knows those firms are good. If the knowledge is already public, the investor will be forced to pay high price for those firms and will not realize a superior rate of return.
The trick is to identify firms that are better than everyone else’s estimate.
It is not good enough to do a good analysis of a firm; you can make money only if your analysis is better than that of your competitors.
13.The Role of Portfolio Management in an Efficient Market
If the market is efficient, why not throw darts at the stock price quotations given in a business newspaper like Economic Times instead of trying to choose a stock portfolio?
This is a tempting conclusion to draw the notion that security prices are fairly set, but it is far from being true.
There is a role for rational portfolio management, even in perfectly efficient markets.
A rational security selection, even in an efficient market, calls for the selection of a well-diversified portfolio providing the systematic risk level that the investor wants.
14.The Role of Portfolio Management in an Efficient Market
Rational investment policy requires tax consideration be reflected in security choice. High tax bracket investors find it advantageous to buy tax exempt municipal bonds despite their relatively low pre tax yields, whereas these bonds are unattractive to investors in low tax bracket.
At a more subtle level high tax bracket investors might want to tilt their portfolios in the direction of capital gains income as opposed to dividend or interest income, because the option to defer the realization of capital gains is more valuable.
They also will be more attracted to investment opportunities for which returns are sensitive to tax benefits such as real estate ventures.
15.The Role of Portfolio Management in an Efficient Market
A third argument for rational portfolio management relates to the particular risk profile of the investor. For example, an ICICI Bank’s executive whose annual bonus depends on ICICI Bank’s profits generally should not invest additional amounts in banking stocks.
Investors of varying ages also might warrant different portfolio policies with regard to risk bearing.
Thus to summarize the role for portfolio management is essential even in efficient markets because investor’s optimal position will vary according to factors such as age, tax bracket, risk aversion and employment.
The role of the portfolio manager in an efficient market is to tailor the portfolio to these needs, rather than to beat the market.
16.Random walk theory
It suggests that the successive price changes are independent. & these successive price changes are randomly distributed. This model argues that all publicly available information is fully reflected on the stock prices & further thestock prices instantaneously adjust themselves to the available information.
17.Random walk and technical analysis
The random walk theory is inconsistent with technical analysis. Random walk states that successive price changes are independent, while the technical analysts claim that the historical price behaviour of the stock will repeat itself into the future and that by studying this past behaviour the chartist can predict the future.
If security prices reflect all currently available information, then price changes must reflect new information.
An event study describes a technique of empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price.
As per the Single Index Model, the stock return r, during a given period is mathematically represented as
rt = a + b*rMt + et
Where rMt is the market’s rate of return during the period and et is the part of a security’s return resulting from firm specific events. The parameter ‘b’ measures sensitivity to the market return and ‘a’ is the average rate of return the stock would realize in a period with zero market return.
The residual, et, is the stock’s return over and above what one would predict based on broad market movements in that period, given the stock’s sensitivity to the market. et is also referred as abnormal return- the return beyond what would be predicted from market movements alone.
One concern that complicates event studies arises from leakage of information. Leakage occurs when information regarding a relevant event is released to a small group of investors before official public release. In this case the stock price might start to change days or weeks before the official announcement date.
A better indicator is cumulative abnormal return which is simply the sum of all abnormal returns over the time period of interest
20.The Small Firm Effect
This effect was documented by Banz.
According to its average annual returns are consistently higher on the small firm portfolios.
In ‘low capitalization’ stocks investors can measure firm size at little cost and one would expect minimal effort to yield large rewards
21.The Neglected Firm Effect and Liquidity Effect
The information deficiency makes smaller and neglected firms riskier investments that command higher returns. The neglected firm risk premium is not strictly a market inefficiency, but is a type of risk premium.
Investors demand a rate-of-return premium to invest in less liquid stocks that entail higher trading costs.Because small and less analyzed stocks as a rule are less liquid, the liquidity effect might be partial explanation of their abnormal returns.
22.Post- Earnings-Announcement Price Drift
A fundamental principle of efficient markets is that any new information ought to be reflected in stock prices very rapidly.
The ‘news content’ of an earnings announcement can be evaluated by comparing the announcement of actual earnings to the value previously expected by market participants. The difference is the µearnings surprise.
There is a large abnormal return (a large increase in cumulative abnormal return) on the earnings announcement day (time 0). The abnormal return is positive for positive surprise firms and negative for negative surprise firms.
23.Are market efficient?
There is a telling joke about two economists walking down the street. The spot a Rs.20 bill on the sidewall. One starts to pick it up, but other one says, Don’t bother, if the bill were real someone would have picked it up already.
The lesson is clear. An overly doctrinaire belief in efficient markets can paralyze the investor and make it appear that no research effort can be justified.
We conclude that markets are very efficient, but that rewards to the especially diligent, intelligent or creative may in fact be waiting