AC422 (Financial Risk Mangement)

Market Efficiency
Dr. Luis R. Alamil, CPA, FFA-Aus., Ph.D(BA)
Course Facilitator
 Learning Outcomes
• After studying this chapter, you shall be able to:
1. Define market efficiency.
2. Explain the efficient market theory and its implications
to portfolio management and market regulation.
3. Analyze the causes of market failure.
4. Analyze market liquidity and its importance in business
and apply the measures towards liquidity.
5. Explain financial development and role of financial
intermediaries in risk management.
 MARKET EFFICIENCY
• Market efficiency refers to a market where
prices represent all relevant financial
information about an underlying asset or
security.
o The more information that all market
players will have, the more efficient the
market is. It, thus, provides an equal
opportunity for buyers and sellers to
execute trades and make profits while
minimizing transaction costs.
 MARKET EFFICIENCY
• When you place money in the stock market,
the goal is to generate a return on the capital
invested.
• Many investors try not only to make a
profitable return, but also to outperform, or
beat, the market.
• However, market efficiency suggests at any
given time, prices fully reflect all available
information about a particular stock and/or
market
 How Does a Market Become Efficient?
• Investors must perceive the market is inefficient and
possible to beat.
o Investment strategies intended to take advantage of
inefficiencies are actually the fuel that keeps a market
efficient.
o A market has to be large and liquid.
o Accessibility and cost information must be widely available
and released to investors at more or less the same time.
o Transaction costs have to be cheaper than an investment
strategy's expected profits.
• Investors must also have enough funds to take
advantage of inefficiency until, according to the EMH, it
disappears again.
 Efficient Market Theory or EMT
• Aka: Efficiency Market Hypothesis [EMH])
• A concept in finance that asserts that:
• “ financial markets are highly efficient and
that prices of assets fully reflect all available
information. “
 Efficient Market Theory or EMT
• Its applications have had significant
implications for investment decision-making,
portfolio management, and market regulation.
• According to the EMH, no investor has an
advantage in predicting a return on a stock
price
o no one has access to information not
already available to everyone else.
 Efficient Market Theory or EMT
• EMT is grounded in the notion that market
participants are rational and have access to all
relevant information.
o in an efficient market, prices of securities
are determined by market forces, and any
new information is immediately
incorporated into prices.
• This implies that it is impossible to outperform
the market consistently, as prices already
reflect all available information.
 Category of EMT
1. Weak Form: EMT asserts that all past prices of
securities are reflected in current prices, and it is
impossible to use past prices to predict future prices.
2. Semi-strong Form: EMT suggests that current prices
reflect all publicly available information, including
financial statements and other disclosures.
3. Strong Form: EMT suggests that current prices reflect
all available information, including public and private
information. In this case, insider trading would not be
profitable, as prices already reflect all available
information
 Category of EMT
• Expanded content of the EMT forms:
1. Weak:
• This form reveals all past information about asset or
security pricing. However, past pricing details reflected
in current prices are insufficient to assist investors in
determining correct future trading prices.
• As a result, the weak form market efficiency will only
result in asset undervaluation or overvaluation,
affecting trade decisions.
 Category of EMT
• Expanded content of the EMT forms:
2. Semi-Strong:
• It indicates that current prices consider all publicly
available information about an asset or security.
• It also offers previous price details. As a result, it
discourages investors from benefitting above the
market by trading on the inside information.
 Category of EMT
• Expanded content of the EMT forms:
3. Strong:
• It is the result of combining weak and semi-strong
forms.
• This form shows market prices based on all accessible
information (public, insider, and private).
• This insider knowledge, however, is neutral and
available to all traders.
• As a result, despite having access to insider
information, it ensures that all investors profit equally.
 Efficiency examples (EMT)
• Example #1:
• Assume that companies A and B are up for takeover.
These companies’ stock values are lenient and stable
for a few days, with only minor fluctuations. However,
as soon as it was announced that a well-known
corporation would be taking over both of them, their
stock prices jumped.
• In this instance, the takeover announcement adds new
information to the current data for the companies’
stocks, resulting in a price change.
• As a result, the rise in stock prices indicates new
positive information to the companies.
 Efficiency examples (EMT)
• Example #2:
• Mary, a trader, is looking forward to purchasing stocks
at a reduced price on one market and selling them at a
higher price on another market.
• This type of trading, known as arbitrage, is the process
of profiting from a pricing discrepancy.
• Unfortunately, even though an arbitrager can make a
risk-free return in this situation, the market’s overall
efficiency suffers.
• As a result, markets prohibit arbitrage and impose
restrictions on acts that impede market efficiency.
 Empirical Evidence Supporting Efficient Market
Theory
• Stock Prices Follow Random Pattern: One of the earliest
and most influential studies was conducted by Fama himself.
In his study, he found that stock prices in the United States
followed a random walk pattern and were not predictable.
• Market Prices Are Unpredictable: Other studies have found
similar results, suggesting that market prices are
unpredictable and follow a random walk pattern.
• Actively Managed Funds Underperform: In addition, some
studies have found that actively managed funds, which seek
to outperform the market, often underperform the market
after accounting for fees and transaction costs.
 Implications of EMT

• EMT has significant implications on the following:

• Portfolio Management:
• EMT suggests that it is impossible to outperform
the market consistently, and as such, active
portfolio management strategies, such as stock
picking and market timing are unlikely to be
successful in the long run.
• Instead, EMT suggests that investors should focus
on passive investment strategies such as index
funds that aim to replicate market performance.
 Implications of EMT

• EMT has significant implications on the following:

• Market Regulation:
• The implications of EMT for market regulation are
also significant. If prices are always efficient, then
it may not be necessary to regulate markets to
ensure that prices are fair.
• However, some argue that regulation is still
necessary to prevent fraud and market
manipulation, which can lead to market
inefficiencies and undermine investor confidence.
 Alternatives to Efficient Market Theory
• Several alternative theories and perspectives to EMT:
• Technical Analysis: A popular approach to investing
that involves analyzing past market data, such as price
and volume, to predict future price movements.
• Fundamental Analysis: This involves analyzing a
company's financial statements, industry trends, and
macroeconomic factors to determine its intrinsic value.
• Value Investing: This strategy involves identifying
undervalued securities and investing in them with the
expectation that their value will increase over time
MARKET EFFICIENCY AND MARKET FAILURE
• Market efficiency also plays a crucial role in
allocating resources to produce consumer-
friendly goods.
• Resource allocation efficiency refers to a
market where the value obtained for goods is
equivalent to the predicted value.
MARKET EFFICIENCY AND MARKET FAILURE
• Market failure, on the contrary, occurs when
resource allocation efficiency is not attained.
• The market is likely to fail when the price
mechanism fails to account for all costs and
advantages essential for consumers when buying
and using an item. In other words, when price and
quality do not match, the market fails.
• To address market failure, the government enacts
legislation, imposes taxes, gives subsidies, offers
tradable permits, etc., depending on the nature of
the market.
 How are market efficiency and market
failure related?
• Market efficiency influences the allocation of
resources to generate consumer-friendly items.
• It refers to a market in which the value gained for
commodities is equal to the value projected.
• Market failure happens when resource allocation
efficiency is not achieved.
o For example, the market is likely to fail when the price
mechanism fails to account for all costs and benefits
required for consumers to buy and utilize an item.
o In other words, the market fails when price and quality do
not match.
 MARKET LIQUIDITY
• Liquidity refers to the efficiency or ease with
which an asset or security can be converted
into ready cash without affecting its market
price.
• The most liquid asset of all is cash itself.
• The more liquid an asset is the easier and
more efficient it is to turn it back into cash.
• Less liquid assets take more time and may
have a higher cost.
 MARKET LIQUIDITY
• The term “liquidity” is, however, frequently
used loosely and it is often difficult to
disentangle precisely what concept is meant in
this respect.
• It is useful to recall that economic theory
offers at least two different concepts of
liquidity.
 CONCEPT OF MARKET LIQUIDITY
• The first concept is called monetary liquidity and it
pertains to the quantity of liquid assets in the economy,
which is in turn related to the level of interest rates.
• A second concept is market liquidity, which is generally
seen as a measure of the ability of market participants
to undertake securities transactions without triggering
large changes in their prices.
• These two concepts are quite distinct from one another
and although there can be relationships between them
they are rather complex and by no means direct