Download Topic Note-Market efficiency

1
MF807
Fall 2008
Prof. Thomas Chemmanur
Topic Note on Market Efficiency
1. Capital Market Efficiency
The purpose of the capital markets is to transfer funds between lenders (savers)
and borrowers (producers) in such a way that all projects which create value (in the
sense that they are positive NPV projects) are funded (and therefore implemented). To
do this in a proper manner, capital markets have to be informationally efficient. In an
efficient capital market, prices fully and instantaneously reflect all available relevant
information: this means that when assets are traded, prices are accurate signals, which
can be used by investors for capital allocation.
Why is it important that markets be efficient? I will illustrate why with an
example. Consider the case of an entrepreneur who has a promising project which can
generate cash flows with a present value of $ H. The investment required for this
project is $1. The NPV of this project is then $ (H - 1).
We know that whenever a project has a positive NPV, it makes sense to invest in
it. Assume that our entrepreneur's project is a positive NPV project: ie., H - 1 > 0. Now,
if our entrepreneur approaches the stock market to raise capital for his project, and if
the stock market is informationally efficient, then the entrepreneur can get $ H for the
entire equity in his company, and can therefore undertake the project. However,
consider the case where the stock market is not informationally efficient, and investors
are unable to tell the difference between our entrepreneur's 'good' project and other
projects with present value of cash flows equal to $L. (Assume that these projects also
2
have an investment requirement of $1, with
NPV = $(L -1) < 0 : ie., these are
negative NPV projects). Assume further that even though investors can't tell the two
projects apart, they know, when faced with any project, that there is a 50% chance
that the project is of either type. Then, even if our H type entrepreneur approaches the
stock market, he will get only the average value across good and bad projects, ie., (H +
L)/2 for the entire equity in his company. Then, if (H + L)/2 < $1, our entrepreneur
with the good project will not be able to undertake it! This is an important problem
when markets are not informationally efficient: all positive NPV projects will not get
funded.
Thus an efficient market is one in which entrepreneurs get the "true" price for
the securities they sell to investors. If an entrepreneur sells securities in an efficient
market, the transaction is neither a positive NPV transaction nor a negative NPV
transaction. It is a zero NPV transaction, so that investors get exactly what they paid
for.
When can we expect to find an efficient market? We can expect markets to be
efficient when information is widely and cheaply available to investors, there are a large
number of traders so that each trader is insignificant compared to the market as a
whole and there are relatively low transactions costs involved in trading so that
investors will trade to take advantage of any mispricing they observe, leading prices to
reflect all information available with investors.
2. Three possible levels to which capital markets may be efficient
The ideal of market efficiency in the example I discussed above is quite strong:
3
this implied that no investor can earn excess returns using any information, whether
publicly available or not. This form of the efficient markets hypothesis is usually called
strong form efficiency. Usually, real world capital markets are not strong form efficient.
For example, we know from academic studies and reports in the press that people who
trade on insider information are able to make handsome profits for themselves, which is
a violation of strong-form efficiency. Academic studies have tested three different
hypotheses about market efficiency, depending on the type of information with respect
to which market efficiency is defined:
1. Weak-form efficiency: A market is weak-form efficient if current prices fully reflect
all the information contained in past prices (or equivalently, return data). Thus, if the
market is even weak-form efficient, no investor will be able to earn excess returns by
developing trading rules based on historical price or return information. Thus, weakform efficiency precludes investors earning abnormally high returns by using "filter
rules"; it also precludes technical analysts (e.g., chartists) from earning abnormally
high returns.
2. Semistrong-form efficiency: A market is semi-strong efficient if the prices of all
securities reflect all publicly available information (this includes past price and return
data as well as other publicly available information such as the annual reports of
companies, investment advisory data such as the "Heard on the Street" column in the
Wall Street Journal or ticker tape information). Therefore, if the market is efficient in
the semi-strong sense, no investor can earn excess returns using any publicly available
information.
3. Strong-form efficiency: A market is strong-form efficient if the current price of all
4
securities reflects all available information, whether such information has been publicly
released or not. This implies that even those who trade on insider information will not
be able to earn excess returns in a market which is strong-form efficient.
It should be clear from the above definitions that the three hypotheses above are
nested: i.e., if a market is strong form efficient, it is also semi-strong form efficient and
weak form efficient; if it is only semi-strong form efficient, it is also weak form efficient
(since the past history of prices is also a part of publicly available information).
Extensive empirical tests in many financial markets have shown that, while most of
these are not strong-form efficient, almost all are semistrong-form efficient.
3. Characteristics of an efficient capital market
We can test whether capital markets (eg. the stock market) are in fact efficient
by checking whether the observed behavior of market prices conform to that predicted
by the different forms of the efficient markets concept. For example, if the stock market
are weak form efficient, we should not be able to predict (forecast) future stock prices.
Neither should there be any consistent pattern in stock returns. If there are any such
patterns, investors can trade using technical trading rules called "filter rules" to take
advantage of such patterns and make abnormal profits. In practice, academic studies
have shown that markets are efficient enough that it is not possible to make such
profits using filter rules (if we also include the transactions costs involved in trading).
Also, changes in stock prices are quite random, so that the time series of stock returns
resembles a random walk. (If prices reflect all available information, then prices will
change only when new information arrives. But new information, by definition, is
5
something that cannot be predicted ahead of time. Therefore, price changes cannot be
predicted ahead of time, and are random).
Another implication of market efficiency is that there can be no financial illusions:
We know from our study of stock and bond valuation that investors should only be
concerned with cash flows when valuing these securities, not accounting figures.
However, quite often firm managers devote considerable time and effort to ensure that
their earnings report presents the best picture possible to stockholders, in the hope that
this will have a favorable impact on the stock price. If markets are efficient, on the
other hand, this should not be the case, and prices should not be affected irrespective
of the way in which earnings figures are presented in the accounting reports. Here
again, several academic studies in different contexts have shown that this is indeed the
case, and it is difficult to affect security prices through cosmetic changes which do not
affect the firm's cash flows.
4. Market efficiency, security analysts and portfolio managers
If markets fully reflect all available information, what is the role of security
analysts? If information generation is costless, indeed they do not have any useful role
in an efficient market. However, we know that producing information is costly. Thus if
nobody undertakes information production, prices will not contain any information.
Thus, when information production is costly, the role of security analysts is to
undertake information production, and earn a fair return on this activity. However,
security analysts compete with each other, so that if the return to security analysis
becomes large, new individuals will enter the analysis business so that on average, they
6
get a fair return. In fact, in a market with costly information, security analysts have an
important role to play in making markets efficient. There are two kinds of analysts: the
technical analysts study the past price record, and try to exploit patterns in the past
series of prices, until these patterns disappear from prices. Fundamental analysts study
the business of the firm and other available public information about the firm being
evaluated to unearth undervalued securities. They will then trade to exploit such
opportunities, so that prices come back in line with true underlying values.
Another implication the efficient markets hypothesis is for mutual fund portfolio
managers. Mutual funds are companies which hold portfolios of stocks and other
securities. Investors who invest in these funds thus invest in a large portfolio, whose
composition is changed from time to time at the discretion of the managers of these
funds. Mutual funds claim that they provide two kinds of services to their clients: First,
they help an investor to diversify, thus reducing the amount of unsystematic risk he
must face. Second, they claim they are able to use their professional expertise in
selecting the securities which constitute the portfolio held by the fund and thus to earn
abnormally high returns (abnormally high relative to the risk of the fund). This second
claim is contradictory to the semi-strong form of the efficient markets hypothesis
unless, for some reason, mutual fund managers can consistently obtain information
that is not publicly available.
How can we test the claims made by mutual fund managers? One way to test
this is using the Capital Asset Pricing Model. The capital asset pricing model states that
if all investors have identical information, the expected return on any asset should be
linearly related to its systematic risk measured by ß. Specifically,
7
(1)
ri = rF + βi( rm - rF)
Therefore, assuming that the CAPM is true, we can use expected return as
predicted by the CAPM as a benchmark to evaluate the actual performance of portfolio
_
managers. Let r A be the actual average return obtained on the portfolio over the period
over which we want to evaluate the portfolio's performance. Then, define ξi by,
(2)
ξi = rA - ri = rA - [rF + βi( rm - rF)]
ξi can be thought of as the "abnormal performance" of the i th portfolio in the period
under consideration. Then, if ξi > 0, the portfolio over-performed compared to its
riskiness during this period; if ξi < 0, the portfolio under-performed. Most academic
studies have found that while there are some portfolios which have consistently positive
ξ s, the average value of ξ across all available mutual funds,

N
i
 i / N is negative
(where N is the number of funds in the sample, and the return data used is net of
operating costs of the fund). This means that, on average, mutual funds under-perform
corresponding to the risk of their portfolio! Thus, while some fund managers indeed
seem to have a comparative advantage in producing information, we cannot say that
the semi-strong form of the efficient markets hypothesis is rejected in this case also.
5. How should we think about market efficiency?
The topic of market efficiency is rather controversial, perhaps because it is not
well-understood. It is important to emphasize that market efficiency is not a question
8
with a "yes" or "no" answer. It is best to ask, "to what degree is this market
informationally efficient?" rather than "is this market informationally efficient or not?"
In an efficient market, investors rapidly pounce on new information, analyze it
effectively, revise their expectations about the future cash flows from holding various
securities, and buy or sell securities accordingly. This, in turn, implies that in such a
market, prices will rapidly adjust to new information, and current prices will fully reflect
all available information. Thus, market efficiency does not imply that the market has
any magical qualities in the sense that prices reflect some measure of true value as yet
unknown to everybody; neither does it preclude any large changes in asset prices (in
fact, precisely the opposite: it implies that prices will change rapidly as new
economically relevant information becomes available).
The degree of informational efficiency in any financial market is an empirical
question, which can be tested based on suitable data in that particular security market
with respect to a given context; we cannot make blanket statements about the
efficiency or otherwise of security markets. In general, it has been found that the
capital markets in the more developed economies are more efficient; the greater the
number of market participants, the greater the speed with which investors can make
transactions, and the cheaper such transactions are, the more informationally efficient
the market.