1

The Capital Markets and Market Efficiency

2

Role of the Capital Markets

Definition Economic Function Continuous Pricing Function Fair Price Function

3

Definition

Capital markets trade securities with lives of more than one year

4

Economic Function

The economic function of capital markets facilitates the transfer of money from savers to borrowers– e.g., mortgages, Treasury bonds,

corporate stocks and bonds

5

Continuous Pricing Function

The continuous pricing function of capital markets means prices are available moment by moment– Continuous prices are an advantage to

investors– Investors are less confident in their ability

to get a quick quotation for securities that do not trade often

6

Fair Price Function

The fair price function of capital markets means that an investor can trust the financial system– The function removes the fear of buying or

selling at an unreasonable price

– The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

7

Concept of Efficiency

8

Efficiency defined

Informational efficiency is a measure of how quickly and accurately the market reacts to new information– If the market is informationally very

efficient• Security prices adjust rapidly and

accurately to new information

9

Efficient Market

In an efficient market,

– Market price is an unbiased estimate of

the true value of the investment.

Market Efficiency does not require that

the market price be equal to true value at

every point in time.

10

Efficient Market

Errors in the market price be unbiased

implying that prices can be greater than

or less than true value, as long as these

deviations are random.

Randomness implies that there is an

equal chance that stocks are under or

over valued at any point in time.

11

Example of Efficiency

12

Example of Inefficiency

13

Weak Form

Definition Charting Runs Test

14

Definition

The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past– The current price is a fair one that

considers any information contained in the past price data

– Charting techniques are of no use in predicting stock prices

15

Charting

People who study charts are technical analysts or chartists– Chartists look for patterns in a sequence of

stock prices

– Many chartists have a behavioral element

16

Runs Test

A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance– A run is an uninterrupted sequence of the

same observation

17

Semi-Strong Form

The semi-strong form of the EMH states that security prices fully reflect all publicly available information– e.g., past stock prices, economic reports,

brokerage firm recommendations, investment advisory letters, etc.

18

Semi-Strong Form (cont’d)

Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as:– Stock splits– Cash dividends– Stock dividends

This means investors are seldom going to beat the market by analyzing public news

19

Strong Form

The strong form of the EMH states that security prices fully reflect all relevant public and private information

This means even corporate insiders cannot make abnormal profits by using inside information about their company– Inside information is information not

available to the general public

20

Security Prices and Random Walks The unexpected portion of news follows

a random walk– News arrives randomly and security prices

adjust to the arrival of the news• We cannot forecast specifics of the news very

accurately

21

Anomalies

Definition Low PE Effect Low-Priced Stocks Small Firm and Neglected Firm Effect Market Overreaction January Effect

22

Anomalies (cont’d)

Day-of-the-Week Effect Turn-of-the Calendar Effect Persistence of Technical Analysis Chaos Theory

23

Definition

A financial anomaly refers to unexplained results that deviate from those expected under finance theory– Especially those related to the efficient

market hypothesis

24

Low PE Effect

Stocks with low PE ratios provide higher returns than stocks with higher PEs

Supported by several academic studies

Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

25

Low-Priced Stocks

Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price

There is an optimum trading range

26

Market Overreaction

The tendency for the market to overreact to extreme news– Investors may be able to predict systematic

price reversals

Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

27

January Effect

Stock returns are inexplicably high in January

Small firms do better than large firms early in the year

Especially pronounced for the first five trading days in January

28

Day-of-the-Week Effect

Mondays are historically bad days for the stock market

Wednesday and Fridays are consistently good

Tuesdays and Thursdays are a mixed bag

29

Day-of-the-Week Effect (cont’d) Should not occur in an efficient market

– Once a profitable trading opportunity is identified, it should disappear

The day-of-the-week effect continues to persist

30

Turn-of-the-Calendar Effect

The bulk of the return comes from the last trading day of the month and the first few days of the following month

For the rest of the month, the ups and downs approximately cancel out

31

Persistence of Technical Analysis Technical analysis refers to any technique in

which past security prices or other publicly available information are employed to predict future prices

Studies show the markets are efficient in the weak form

Literature based on technical techniques continues to appear but should be useless

32

Chaos Theory

Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic

Econophysics refers to the application of physics principles in the analysis of stock market behavior– e.g., an investment strategy based on

studies of turbulence in wind tunnels

33