Corporate Financial Management Term paper

On

MARKET EFFICIENY and its problems

SUBMITTED BY

JOEL . J (0409003)

KRISHNA VAZRAPU (0409005)

SARATH CHAND (0409011)

M.S.TEJASWEE (0409015)

RAVI TEJA REDDY.S (0409020)

CONTENTS

INTRODUCTION...........................................................................................................................3

INVESTMENT VERSUS FINANCING DECISIONS...................................................................3

EFFICIENT FINANCIAL MARKET/ MARKET EFFICENY......................................................4

HOW DOES A MARKET BECOME EFFICIENT?......................................................................4

IMPLICATIONS OF MARKET EFFICIENCY.............................................................................5

MARKET EFFICIENCY LEVELS................................................................................................5

MARKET EFFICIENCY TYPES...................................................................................................6

TESTING MARKET EFFICIENCY...............................................................................................7

EFFICIENT MARKET HYPOTHESIS (EMH).............................................................................7

RANDOM WALK THEORY.........................................................................................................8

THE EMH RESPONSE...................................................................................................................8

THE EFFECT OF EFFICIENCY: NON-PREDICTABILITY.......................................................9

ANAMOLIES: THE CHALLENGE TO EFFICIENCY………...……………...……..…………9

THE JANUARY EFFECT.........................................................................................................10

THE WEEKEND EFFECT........................................................................................................11

EFFICIENT MARKET: THE EVIDENCES................................................................................12

THE SIX LESSONS OF MARKET EFFICIENCY WITH EXAMPLES....................................12

CONCLUSION..............................................................................................................................17

REFERENCES:.............................................................................................................................18

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INTRODUCTION

Market efficiency in simple words can be defined as “The degree to which stock prices

reflect all available, relevant information”. Market efficiency has varying degrees: strong, semi-

strong, and weak. Stock prices in a perfectly efficient market reflect all available information.

These differing levels, however, suggest that the responsiveness of stock prices to relevant

information may vary. Market efficiency is directly or implicitly tested any time a study is

performed to identify stock price reactions to certain events such as dividend announcements,

earnings announcements stock splits, large block transactions, repurchase tender offers, and other

public announcements. Traditionally, event study methodology is used to evaluate the reaction of

the market to certain corporate events. These studies which are specific in nature are designed to

measure market efficiency at certain points in time and only in conjunction with specific events.

A more encompassing or macro evaluation of market efficiency can be made by testing whether

or not the returns in a market follow a random walk process over a longer period of time.

Financial theory predicts that stock prices should fluctuate randomly in the short run if the stock

market is efficient. The semi-strong form of the Efficient Market Hypothesis (EMH) holds that

the market instantaneously absorbs all relevant information as it becomes publicly available.

Hence, daily returns should fluctuate as random white noise.

INVESTMENT VERSUS FINANCING DECISIONS

Investment analysis is crucial to determining the maximum rate of return on investments

in order to make investment decisions. Financing decisions relate to raising of capital structure of

the company. Investment and financing decisions need to be made separately. If made separately,

new projects will be evaluated on a consistent basis. Profitability can be determined in a true

fashion. Financing and investment decisions are made by different departments and therefore

need to be considered separately. Benefits of special financing can be quantified and included in

the investment proposal. Different cash flows are rated differently in investment and financial

decisions, therefore different discount rates are used. Mixing these decisions will cause

improperly allocated resources.

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EFFICIENT FINANCIAL MARKET/ MARKET EFFICENY

In the 1970s Eugene Fama defined an efficient financial market as "one in which prices

always fully reflect available information”.

The most common type of efficiency referred to in financial markets is the allocative

efficiency, or the efficiency of allocating resources. In an efficient market no one could

outperform the market by using the same information that is already available to all investors,

except through luck. This includes producing the right goods for the right people at the right

price.

A trait of allocatively efficient financial market is that it channels funds from the ultimate

lenders to the ultimate borrowers in a way that the funds are used in the most socially useful

manner.

HOW DOES A MARKET BECOME EFFICIENT?

In order for a market to become efficient, investors must perceive that a market is

inefficient and possible to beat. Ironically, investment strategies intended to take advantage of

inefficiencies are actually the fuel that keeps a market efficient.

A market has to be large and liquid. Information has to be widely available in terms of

accessibility and cost and released to investors at more or less the same time. Transaction costs

have to be cheaper than the expected profits of an investment strategy. Investors must also have

enough funds to take advantage of inefficiency until, according to the EMH (Efficient Market

Hypotheses), it disappears again. Most importantly, an investor has to believe that she or he can

outperform the market.

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IMPLICATIONS OF MARKET EFFICIENCY:

The three important points that imply market efficiency are:-

(a) In an efficient market, equity research and valuation would be a costly task that provided no

benefits. The odds of finding an undervalued stock would always be 50:50, reflecting the

randomness of pricing errors. At best, the benefits from information collection and equity

research would cover the costs of doing the research.

(b) In an efficient market, a strategy of randomly diversifying across stocks or indexing to the

market, carrying little or no information cost and minimal execution costs, would be superior to

any other strategy, that created larger information and execution costs. There would be no value

added by portfolio managers and investment strategists.

(c) In an efficient market, a strategy of minimizing trading, i.e., creating a portfolio and not

trading unless cash was needed, would be superior to a strategy that required frequent trading.

MARKET EFFICIENCY LEVELS

They are identified at three levels:

1. Weak-form efficiency

Prices of the securities instantly and fully reflect all information of the past prices. This

means future price movements cannot be predicted by using past prices.

2. Semi-strong efficiency

Asset prices fully reflect all of the publicly available information. Therefore, only

investors with additional inside information could have advantage on the market.

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3. Strong-form efficiency

Asset prices fully reflect all of the public and inside information available. Therefore, no

one can have advantage on the market in predicting prices since there is no data that would

provide any additional value to the investors.

MARKET EFFICIENCY TYPES

James Tobin identified four efficiency types that could be present in a financial market. They are

1. Information arbitrage efficiency

Asset prices fully reflect all of the privately available information (the least demanding

requirement for efficient market, since arbitrage includes realizable, risk free transactions)

Arbitrage involves taking advantage of price similarities of financial instruments between

2 or more markets by trading to generate losses.

It involves only risk-free transactions and the information used for trading is obtained at

no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that

arbitrage is a result of market inefficiency. This reflects the weak-information efficiency model.

2. Fundamental valuation efficiency

Asset prices reflect the expected past flows of payments associated with holding the

assets (profit forecasts are correct, they attract investors)

Fundamental valuation involves lower risks and less profit opportunities. It refers to the

accuracy of the predicted return on the investment.

Financial markets are characterized by predictability and inconsistent misalignments that

force the prices to always deviate from their fundamental valuations. This reflects the semi-

strong information efficiency model.

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3. Full insurance efficiency

It ensures the continuous delivery of goods and services in all contingencies.

4. Functional/Operational efficiency

The products and services available at the financial markets are provided for the least cost

and are directly useful to the participants.

TESTING MARKET EFFICIENCY

Tests of market efficiency look at the whether specific investment strategies earn excess

returns. Some tests also account for transactions costs and execution feasibility. Since an excess

return on an investment is the difference between the actual and expected return on that

investment, there is implicit in every test of market efficiency a model for this expected return. In

some cases, this expected return adjusts for risk using the capital asset pricing model or the

arbitrage pricing model, and in others the expected return is based upon returns on similar or

equivalent investments. In every case, a test of market efficiency is a joint test of market

efficiency and the efficacy of the model used for expected returns. When there is evidence of

excess returns in a test of market efficiency, it can indicate that markets are inefficient or that the

model used to compute expected returns is wrong or both. While this may seem to present an

insoluble dilemma, if the conclusions of the study are insensitive to different model

specifications, it is much more likely that the results are being driven by true market

inefficiencies and not just by model misspecifications

EFFICIENT MARKET HYPOTHESIS (EMH)

Eugene Fama in 1970 created the Efficient Market Hypothesis (EMH) theory, which

states that in any given time, the prices on the market already reflect all known information, and

also change fast to reflect new information.

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This means no one could outperform the market by using the same information that is

already available to all investors, except through luck.

However, this suggests that at any given time, prices fully reflect all available

information on a particular stock and/or market. Thus, according to the EMH, no investor has an

advantage in predicting a return on a stock price because no one has access to information not

available to everyone.

RANDOM WALK THEORY

Another theory related to the efficient market hypothesis created by Louis Bachelier is

the “random walk” theory, which states that the prices in the financial markets evolve randomly

and are not connected, they are independent of each other.

Therefore, identifying trends or patterns of price changes in a market couldn’t be used to

predict the future value of financial instruments.

THE EMH RESPONSE

The EMH does not dismiss the possibility of anomalies in the market that result in the

generation of superior profits. In fact, market efficiency does not require prices to be equal to fair

value all of the time. Prices may be over- or undervalued only in random occurrences, so they

eventually revert back to their mean values. As such, because the deviations from a stock's fair

price are in themselves random, investment strategies that result in beating the market cannot be

consistent phenomena.

Furthermore, the hypothesis argues that an investor who outperforms the market does so

not out of skill but out of luck. EMH followers say this is due to the laws of probability: at any

given time in a market with a large number of investors, some will outperform while other will

remain average.

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When money is put into the stock market, it is done with the aim of generating a return

on the capital invested. Many investors try not only to make a profitable return, but also to

outperform, or beat, the market.

Thus, according to the EMH, no investor has an advantage in predicting a return on a

stock price because no one has access to information not already available to everyone else.

THE EFFECT OF EFFICIENCY: NON-PREDICTABILITY

The nature of information does not have to be limited to financial news and research

alone; indeed, information about political, economic and social events, combined with how

investors perceive such information, whether true or rumored, will be reflected in the stock price.

According to EMH, as prices respond only to information available in the market, and, because

all market participants are privy to the same information, no one will have the ability to out-

profit anyone else.

In efficient markets, prices become not predictable but random, so no investment pattern

can be discerned. A planned approach to investment, therefore, cannot be successful.

This "random walk" of prices, commonly spoken about in the EMH school of thought,

results in the failure of any investment strategy that aims to beat the market consistently. In fact,

the EMH suggests that given the transaction costs involved in portfolio management, it would be

more profitable for an investor to put his or her money into an index fund.

ANOMALIES: THE CHALLENGE TO EFFICIENCY

In the real world of investment, however, there are obvious arguments against the EMH.

There are investors who have beaten the market - Warren Buffett, whose investment strategy

focuses on undervalued stocks, made millions and set an example for numerous followers. There

are portfolio managers who have better track records than others, and there are investment

houses with more renowned research analysis than others. So how can performance be random

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when people are clearly profiting from and beating the market?

Counter arguments to the EMH state that consistent patterns are present. Here are some

examples of some of the predictable anomalies thrown in the face of the EMH: the January

effect is a pattern that shows higher returns tend to be earned in the first month of the year; "blue

Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday

morning because of the weekend effect, the tendency for prices to be higher on the day before

and after the weekend than during  the rest of the week.

Studies in behavioral finance, which look into the effects of investor psychology on stock

prices, also reveal that there are some predictable patterns in the stock market. Investors tend to

buy undervalued stocks and sell overvalued stocks and, in a market of many participants, the

result can be anything but efficient.

THE JANUARY EFFECT

Studies of returns in the United States and other major financial markets consistently

reveal strong differences in return behavior across the months of the year. Returns in January are

significantly higher than returns in any other month of the year. This phenomenon is called the

year-end or January effect, and it can be traced to the first two weeks in January.

The relationship between the January effect and the small firm effect adds to the

complexity of this phenomenon. The January effect is much more accentuated for small firms

than for larger firms, and roughly half of the small firm premium, described in the prior section,

is earned in the first two days of January. A number of explanations have been advanced for the

January effect, but few hold up to serious scrutiny. One is that there is tax loss selling by

investors at the end of the year on stocks which have 'lost money' to capture the capital gain,

driving prices down, presumably below true value, in December, and a buying back of the same

stocks in January, resulting in the high returns. The fact that the January effect is accentuated for

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stocks which have done worse over the prior year is offered as evidence for this explanation.

There are several pieces of evidence that contradict it, though.

First, there are countries, like Australia, which have a different tax year, but continue to

have a January effect. Second, the January effect is no greater, on average, in years following

bad years for the stock market, than in other years. A second rationale is that the January effect is

related to institutional trading behavior around the turn of the years. It has been noted, for

instance, that ratio of buys to sells for institutions drops significantly below average in the days

before the turn of the year and picks to above average in the months that follow. It is argued that

the absence of institutional buying pushes down prices in the days before the turn of the year and

pushes up prices in the days after.

THE WEEKEND EFFECT

The weekend effect is another return phenomenon that has persisted over extraordinary

long periods and over a number of international markets. It refers to the differences in returns

between Mondays and other days of the week. The returns on Mondays are significantly

negative, whereas the returns on every day of the week are not. There are a number of other

findings on the Monday effect that have fleshed out. First, the Monday effect is really a weekend

effect since the bulk of the negative returns is manifested in the Friday close to Monday open

returns. The returns from intraday returns on Monday are not the culprits in creating the negative

returns. Second, the Monday effect is worse for small stocks than for larger stocks. Third, the

Monday effect is no worse following three-day weekends than two-day weekends. There are

some who have argued that the weekend effect is the result of bad news being revealed after the

close of trading on Friday and during the weekend.

This reveals that more negative earnings reports are revealed after close of trading on

Friday. Even if this were a widespread phenomenon, the return behavior would be inconsistent

with a rational market, since rational investors would build in the expectation of the bad news

over the weekend into the price before the weekend, leading to an elimination of the weekend

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effect. The presence of a strong weekend effect in Japan, which allowed Saturday trading for a

portion of the period studies here indicates that there might be a more direct reason for negative

returns on Mondays than bad information over the weekend. As a final note, the negative returns

on Mondays cannot be just attributed to the absence of trading over the weekend. The returns on

days following trading holidays, in general, are characterized by positive, not negative, returns.

Paul Krugman, MIT economics professor, suggests that because of the mass mentality of

the trendy, short-term shareholder, investors pull in and out of the latest and hottest stocks. This

results in stock prices being distorted and the market being inefficient. So prices no longer reflect

all available information in the market. Prices are instead being manipulated by profit seekers.

EFFICIENT MARKET: THE EVIDENCES

Evidence of Financial Market Efficiency

Predicting future asset prices is not always accurate (represents weak efficiency form)

Asset prices always reflect all new available information quickly (represents semi-strong

efficiency form)

Investors can't outperform on the market often (represents strong efficiency form)

Evidence of Financial Market In-Efficiency

January effect (repeating and predictable price movements and patterns occur on the

market)

Stock market crashes

Investors that often outperform on the market such as Warren Buffet.

THE SIX LESSONS OF MARKET EFFICIENCY WITH EXAMPLES

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Capital markets function sufficiently well in the sense that opportunities for easy profits

are rare. These imply important implications for the financial manager.

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LESSON 1: MARKETS HAVE NO MEMORY

Market having no memory implies weak form of the efficiency hypothesis. i.e., the sequence of

past price changes contains no information about future changes.

Example of corporate financing

Managers’ Inclination:

a.)Favor equity rather than debt financing after an abnormal price rise and be reluctant to issue

stock after a fall in price.

b.)The idea is to catch the market while it is high and to wait for a rebound while it is low.

Lesson: Since the market has no memory, the cycles that financial managers seem to rely on do

not exist.

A Note: High stock prices in general market movement signal expanded investment

opportunities and the need to finance them. We would expect to see firms raise more money in

total when stock prices are historically high. But this does not explain why firms prefer to raise

the extra cash at these times by an issue of equity rather than debt.

LESSON 2: TRUST MARKET PRICES

Reason: In an efficient market, prices impound all available information about the value of each

security.

Implication: There is no way for most investors to achieve consistently superior rates of return.

Firm’s exchange-rate policy or its purchases and sales of debt:

The financial managers should not operate on the basis that they are smarter than others

at predicting currency changes or interest-rate moves. [Otherwise, they will trade a consistent

financial policy for an elusive will-o-the-wisp.]

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Example: Orange County’s losses in 1994

The county treasurer had raised large short-term loans (reverse repo) which he then used

to invest in long-term bonds (reverse floaters) and bet on a fall in interest rates. However,

interest rates subsequently rose and the county had lost $1.7 billion.

LESSON 3: READ THE ENTRAILS

Prices impound all the available information. This implies, if you can learn to read the

entrails, security prices can tell us a lot about the future.

Examples:

1) The market’s assessment of a firm’s bonds (besides the information in its financial

statements) can provide important information about estimating the probability of bankruptcy.

2) Differences between the long-term interest rate and the short-term rate tell you something

about what investors expect to happen to future short-term rates.

Illustration: Current long-term rate higher than the short-term rate. This implies that the future

short-term rates are rising.

Suppose that investors are confident that interest rates are set to rise over the next year

(i.e., future short-term rates will rise).

They will prefer to wait before they make long-term loans, and any firm that wants to

borrow long-term money today will have to offer the inducement of a higher rate of interest. In

other words, the long-term rate of interest will have to be higher than the one-year rate.

Practical Example: The merge of HP and Compaq.

On Sept. 3, 2001, the two firms announced the proposal to merge because of significant

cost structure improvements and access to new growth opportunities. [Note that these two types

of gains are the usual synergies related to a merger.]

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Over the following two days, HP shares underperformed the market by 21% and Compaq

shares underperformed by 16%. On Nov. 6, the Hewlett family announced that it would vote

against the proposal. Investors took heart that the next day HP shares gained 16%.

Note that the merger eventually proves to be successful later in 2003. [The reason could

be that management did have important information that investors lacked.] But the point is that

the price reaction of the two stocks provided a potentially valuable summary of investor opinion

about the effect of the merger on firm value.

LESSON 4: THERE ARE NO FINANCIAL ILLUSIONS

No Financial Illusions: In an efficient market, investors are unromantically concerned with the

firm’s cash flows and the portion of these cash flows to which they are entitled.

Example: Stock dividends and splits

Subdividing the existing shares or distributing more shares as dividends increases the

number of shares outstanding but does not affect the firm’s future cash flows or the proportion of

these cash flows attributable to each shareholder.

A Classic Study of Stock Splits by Fama Et. Al. (1969):

Price rises around the time of the split announcement (before the split takes place).

Implication: The decision to split is both the consequence of a rise in price and the cause of a

further rise. This implies, shareholders are not as hard-headed as we make out. They care about

the form as well as the substance.

Explanation: The study also found that during the subsequent year, two-thirds of the splitting

firms announced above-average increases in cash dividends. There was no unusual rise in the

stock price at any time after the split.

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This implies, the split was accompanied by an explicit or implicit promise of a dividend

increase and the rise in price at the time of the split had nothing to do with a taste for splits but

with the information that it was thought to convey.

A Note: The above-average increases in cash dividends imply that the splitting firms appears to

be unusually successful in other ways.

Asquith et. al. (1989) found that stock splits are frequently preceded by sharp increases in

earnings. Such earnings increases are very often transitory. However, the stock split appears to

provide investors with an assurance that in this case the rise in earnings is indeed permanent.

LESSON 5: THE DO-IT-YOURSELF ALTERNATIVE

The Alternative: In an efficient market, investors will not pay others for what they can do

equally well themselves.

Implication: Many of the controversies in corporate financing center on how well individuals

can replicate corporate financial decisions.

LESSON 6: SEEN ONE STOCK, SEEN THEM ALL

Perfect Substitutes: Investors don’t buy a stock for its unique qualities. They buy it because it

offers the prospect of a fair return for its risk. This implies, stocks should be like very similar

bands of coffee, almost perfect substitutes. Also, the demand for a firm’s stock should be highly

elastic. [If its expected return is low relative to its risk, nobody will want to hold that stock. If

the reverse is true, everybody will scramble to buy.]

Implications of Elastic Demand: You can sell large blocks of stock at close to the market price

as long as you can convince other investors that you have no bad private information.

Evidence:

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1) In June 1977, the Bank of England offered its holding of BP shares for sale at 845 pence. The

bank owned nearly 67 million shares of BP. The total value was about US$970 million.Just

before the Bank’s announcement, the price of BP stock was 912 pence. Over the next two-week

application period, the price drifted down to 898 pence. [Price almost didn’t change.] Thus, by

the final application date, the discount being offered was only 6%. But the discount brings in

applications for US$4.5 billion worth of stock, 4.7 times the amount on offer. [The demand is

indeed highly elastic.]

2) The study on secondary offerings by Scholes (1972) shows that the effect of the offerings was

a slight reduction in the stock price. But the decline was almost independent of the amount

offered. Estimate of the demand elasticity for a firm’s stock was -3,000.

3) Asquith and Mullins (1986) found that new stock issues by utilities drove down their stock

prices on average by only 0.9%.

CONCLUSION

Financial market efficiency is an important topic in the world of Finance. While most

financiers believe the markets are neither 100% efficient, nor 100% inefficient, many disagree

where on the efficiency line the world's markets fall. It can be concluded that in reality a

financial market can’t be considered to be extremely efficient, or completely inefficient. The

financial markets are a mixture of both, sometimes the market will provide fair returns on the

investment for everyone, while at other times certain investors will generate above average

returns on their investment. Ironically, thinking that the financial market is inefficient and that it

can be “beaten” is what is actually keeping the financial market functioning efficiently.

In other words, in the real world, markets cannot be absolutely efficient or wholly

inefficient. It might be reasonable to see markets as essentially a mixture of both, wherein daily

decisions and events cannot always be reflected immediately into a market. If all participants

were to believe that the market is efficient, no one would seek extraordinary profits, which is the

force that keeps the wheels of the market turning.

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In the age of information technology (IT), however, markets all over the world are

gaining greater efficiency. IT allows for a more effective, faster means to disseminate

information, and electronic trading allows for prices to adjust more quickly to news entering the

market. However, while the pace at which we receive information and make transactions

quickens, IT also restricts the time it takes to verify the information used to make a trade. Thus,

IT may inadvertently result in less efficiency if the quality of the information we use no longer

allows us to make profit-generating decisions.

REFERENCES:

PRINCIPLES OF CORPORATE FINANCE- RICHARD A BREALEY

FINANCIAL MANAGEMENT- PRASANNA CHANDRA

WWW.INVESTOPEDIA.COM

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