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Lecture 10
Efficient Markets
Managerial Finance
FINA 6335
Ronald F. Singer
Efficient Markets
Perfect
Capital
Markets
Versus
Efficient
Capital
Markets.
10-2
Forms of Market Efficiency
 Weak
form:
 Semi-strong
 Strong
form:
form:
10-3
Efficient Markets

In general we can say markets are "efficient"
with respect to some information set f if:

Expectations regarding the future price of the
stock given the information contained in f is
equal to the expected price given the current
price.

Beware of expecting too much from market
efficiency arguments:
"Anomalies"
10-4
Why Should Markets Not be Efficient?
1- The speed at which information is
"disseminated" to the market
2- Investors Overreact
Price
INF
Time
10-5
Why Should Markets Be Efficient?
Price
6.50
5.50
5.00
Time
10-6
The Evidence
 Weak
Form:
Definition:
Methodology: Filter Rules
10-7
Weak Form
1.
Change position when
Price
stock price changes by x%.
2.
Compare with buy and hold
t-1
3.
t
Time
Abnormal positive or negative
returns imply weak form inefficiency.
10-8
Weak Form
Results
 Filter rule results in statistically significant
abnormal returns for filters less than 1
1/2%
1 1/2% Filter
Buy and Hold
11.52%
Annual Yield
10.4%
12,814
Number of Trades
-103.59% Floor Traders' Return after
Transaction Costs:
10-9
Semi-Strong Form

Definition:
 Methodology:
 "Event Studies"
1. Define Information
2. Define Abnormal returns
Models of "normal returns"
Rit = αi + ßi Rmt + εit
Market Model
Rit = Rft + ßi(Rmt - Rft) + εit CAPM
If εit ╪ 0; There are abnormal returns
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Semi-Strong Form

Test Procedure
FAMA, FISHER, JENSEN, ROLL(1969)
A. Identify Firms "Announcing" Event
B. Calculate Average residuals, cumulative
Average residuals around the "Event Date"
Example
Company Announcement(t=0)
t= -1
ABC
9/25/80
9/24/80
DEC
8/7/79
8/6/79
IBM
8/3/72
8/2/79
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Then we have εit i=1, ...,N, t = -30...,0,...30
Patterns
Average
Abnormal
Residual
Cumulative
Abnormal
Average
Residual
N
ARt = Σ
i=1
0
1 εit
N
0
T
CART = Σ ARt
t= -30
-30
0
30
Results:
-30
0
30
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Strong Form Market Efficiency

Definition:

Methodology:

Compare trades made by "insiders" to a
buy and hold strategy
Result:
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Anomalies
1. Value Line
2. Weekend Effect
3. Year End Effect
4. Price Earnings Ratio
5. Small Firm
6. Insiders Trading
7.The October Stock Market Crashes
8. Post Announcement Drift.
10-14