Efficient Markets and

Market Price

P D Nimal
Objectives

After completion of this lesson students

should be able:

 To understand the Determination of

Stock Prices

 To understand the Random Walk of

Stock Prices

 To identify and analyze Three

Forms of Market Efficiency

 To carry out the Tests of ME

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Determining the Stock Price

 Demand-to-buy Schedule

 Supply-to-sell Schedule

 Aggregate demand-to-buy and

supply-to-sell schedule

 See figure 4.1,4.2 and 4.3

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Demand–to-buy schedule

4
Supply–to-sell schedule

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Aggregate demand–to-buy and
supply-to-sell schedule

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Security Prices Changes as a
Random Walk

 A chance discovery by Maurice Kendall in

1953 on the behavior of stock and commodity
prices

 Kendall had expected to find regular price

cycles, but to his surprise they did not seem
to exist

 He found that the prices of stocks and

commodities seemed to follow a random walk

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 Security Prices Changes as a
Random Walk Cont…
106.09

103

100 100.43

97.5

95.06

 Binomial tree to explain the Random Walk model

 You are given Rs.100 to play a game. At the end of each week a
coin is tossed. If it is Head, you win 3% and tails, you lose 2.5%.
After two weeks the possible outcomes are as in the figure above.

 See Figure 13.1,13.2 and is 13.3 against the RW?

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 Daily returns of ASPI and Milanka in the
CSE

ASPI Daily Returns From Jan-1985 to Dec-2007

return on day t

Return on dat t+1

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Market Efficiency
 Financial Economists would agree that capital
should channeled to the most desirable places

 The goal of Government is to encourage

Allocationally Efficient Markets where firms with
the most promising opportunities have access to
the needed funds

 A market to be AE, they need to be both

Internally and Externally efficient

 In an Internally efficient market, the transaction

cost is lower and the transaction speed is higher

 In an Externally efficient market, new

information is quickly and correctly adjusted to
the market prices

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The Efficient Market Model
(Efficient Market Hypothesis)

 Imagine a world in which

 All investors have costless access to currently available
information about the future
 All investors are capable analysts
 All investors pay close attention to market prices and
adjust their holdings appropriately

 In such a market a security’s price will be a good

estimate of its Investment Value

 Investment Value is often referred to as the securities

“Fair” or “Intrinsic” value

 If every security’s price equals to its investment value

at all times, the market is an EM

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The Efficient Market Model
(Efficient Market Hypothesis) Cont…

 In an EM a set of information is fully and immediately

reflected in market prices

 Question is what information?

A popular distinction offered by Fama (1970)
 Weak-Form Efficiency
 Semistrong-Form Efficiency
 Strong-Form Efficiency

 This further says that a market is efficient with respect

to a particular set of information if it is impossible to
make abnormal returns (other than by chance) by
using this set of information to formulate buying and
selling decisions

 That is in an efficient market investors should expect to

make only normal returns (market returns) on their
investments
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 The Efficient Market Model
(Efficient Market Hypothesis) Cont…

 Weak-Form Efficient
If it is impossible to make abnormal returns (other than by chance) by
using past prices to formulate buying and selling decisions

 Semistrong-Form Efficient
If it is impossible to make abnormal returns (other than by chance) by
using publicly available information (past prices and other publicly
available information such as accounting statements) to formulate
buying and selling decisions

 Strong-Form Efficient
If it is impossible to make abnormal returns (other than by chance) by
using any information whatsoever to make buying and selling decisions

Typically when people refer to Efficient Markets, they really mean

Semistrong-Form Efficiency, because the use of insider information is
strictly prohibited in almost every market around the world

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 Fama’s Formulation of the
EM Model

[
E ( p j ,t +1 I t ) = 1 + E (rj ,t +1 I t ) p j ,t ]
 In the Case of Weak-Form Efficient
The information set includes past price data

 In the Case of Semistrong-Form Efficient

The information set includes all publicly available data.
 Published financial data
 Government data about the state of the economy
 Earnings data disseminated by companies and analysts

 In the Case of Strong-Form Efficient

The information set includes all publicly available and insider
information
 imminent takeover plans
 extraordinary future earnings announcements

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Fama’s Formulation of the EM Model
cont…

 If markets are efficient, then investors cannot earn abnormal

return (other than by chance) trading on the available information
set

 According to Fama’s notation, the level of over– or undervaluation

of a security is defined as:

x j ,t +1 = p j ,t +1 − E ( p j ,t +1 I t )

E (x j ,t +1 I t ) = 0

 That is, there will be no expected under-or overvaluation of

securities based on the available information set. That information
is always impounded in security prices

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Evidence on Efficient Markets
 Autocorrelation of weekly returns of indices around
the world See Figure 13.4, 13.5

 Average annual returns on 1493 US mutual funds

and the market index (1962-1992) See Figure 13.6

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Observations about Perfectly
Efficient Markets
 Investors should expect to make a fair return on their investment
but no more

 Markets will be efficient only if enough investors believe that they

are not efficient

 Publicly known investment strategies cannot be expected to

generate abnormal returns

 Some investors will display impressive performance records

though they are by chance

 Professional investors should fare no better in picking securities

than ordinary investors

 Past performance is not an indicator of future performance

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Observations about Perfectly Efficient
Markets with Transaction costs

 In a world where it costs money to analyze

securities, analysts will be able to identify mispriced
securities though their gains from doing so will be
exactly off-set by the increased costs

 Investors will do just as well using a passive

investment strategy where they simply buy the
securities in a particular index and hold onto that
investment

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Puzzles and Anomalies

 In early 80s evidence started to appear that there are patterns

of stock returns that investors have apparently failed to exploit
 Size effect

Portfolio Average annual rate of Average Risk

return premium
Nominal Real
TB 3.9 .8 0
GB 5.7 2.7 1.8
CB 6.0 3.0 2.1
S&P 500 13.0 9.7 9.1
Small Firms 17.3 13.8 13.4

 Average annual returns for the period from 1926-2000

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Puzzles and Anomalies Cont…

 Do investors respond slowly to new information

 The Earnings announcement puzzle see figure 13.7
 The new-issue puzzle

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Testing for Market Efficiency

 Event Studies to see whether the price adjustment to new information

quicker. Figure 4.6,4.7 and 13.5 is a real example
 Looking for Patterns to see whether one can find patterns in stock returns
 Examining Performance, analysis of the performance of professional
investors
 Weak-form tests
Early tests have shown that trading on information related to past prices cannot
gain any abnormal returns but recent researches have found that there are
some patterns in stock returns. Ex. Momentum and Contrarians patterns of stock
returns
 Semistrong-form tests
Result have been mixed, most studies have failed to show sufficient
inefficiencies to earn abnormal returns after adjusting for transaction costs
 Strong-form tests
Some studies have indicated that certain analysts have earned higher returns
but whether this ability is due to skill or chance is an open question

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