EFFICIENT MARKET HYPOTHESIS
EMH
+ Assumptions:
§ Market efficiency assumes that a large number of profit maximizing participants are analysing and valuing securities independent of each other.
§ Market efficiency assumes that new information comes to the market in a random fashion and that the timing of news announcements are independent of each other.
§ Investors adjust their estimate of security prices rapidly to reflect their interpretation of the new information received. However, market efficiency does not assume that market participants correctly adjust prices, just that their price adjustments are unbiased. So, some will over adjust and some will under adjust. (i.e. errors in market price are random)
+ The Theory:
§ An efficient capital market is one where the current price of a security fully reflects all the information currently available about that security, including risk.
§ An informationally efficient capital market is one in which security prices adjust rapidly to new information.
+ Implication:
§ There is no possibility that we can consistently make an abnormal return based on the publicly available information.
§ In an efficient market, the expected returns from any investment will be consistent with the risk of that investment over the long term, though there may be deviations from these expected returns in the short term.
+ Note:
§ Market price is an unbiased estimate of the true value of the investment
§ This does not require the market price to be equal to true value at every point in time
§ This requires that the errors in market price be random (unbiased)
Three Forms of EMH
¾ The Weak-Form EMH assumes that current stock prices fully reflect all currently available security market information (historical information). Thus, info like past price and trading volume will have no relationship with the future direction of security prices.
ü If the weak form of the EMH holds, then investors cannot achieve excess returns using technical analysis.
¾ The Semistrong-Form EMH asserts that security prices adjust rapidly to the release of all new public information. Thus current security prices fully reflect all market and non-market public information.
ü If the semistrong form of the EMH holds, then investors cannot achieve excess returns using fundamental analysis.
¾ The Strong-Form EMH asserts that stock prices fully reflect all information from public and private sources. The strong form includes all types of information: market, non-market public, and private (inside) information. This means that no group of investors has monopolistic access to information relevant to the formation of prices.
ü If the strong form of the EMH holds, then no group of investors should be able to consistently achieve excess returns.
ROLE OF PORTFOLIO MANAGER
+ If security markets are completely efficient, portfolio managers will not be able to earn above-market returns. In this case, the portfolio manager has several responsibilities. First, the portfolio manager should seek optimal diversification while minimizing transaction costs. Second, the portfolio manager should help clients understand and quantify their risk tolerances and return needs. Finally, the portfolio manager should monitor both the clients’ needs and circumstances and changes in the capital markets.
+ In other words, portfolio managers must try to create/maintain a proper mix of assets to meet their client’s needs. Managers should always focus on the minimization of transaction costs, taxes, and liquidity costs.
Necessary Conditions for Market Efficiency
¾ It is the actions of investors, sensing bargains and putting into effect schemes to beat the market, that make the markets efficient
¾ The necessary conditions for a market inefficiency to be eliminated are:
o The market inefficiency should provide the basis for a scheme to beat the market and earn excess return. For this to hold:
1. the assets(s), which is the source of inefficiency, has to be traded
2. transaction costs of executing the scheme have to be smaller than the expected profits from the scheme
o There should be profit maximising investors who
1. recognise the potential for excess return
2. can replicate the beat the market scheme that earns excess return
3. have resources to trade on the stock until the inefficiency disappears
o Internal contradiction
à no possibility to beat the market in EM
à require investors to seek ways to beat the market and thus make it efficient
à if markets are efficient, investors will stop looking for inefficiencies, leading to markets becoming inefficient again …
o Self-correcting mechanism
à inefficiencies appear at regular intervals but disappear almost instantaneously when found and traded on.
FURTHER INTERPRETATION
+ The efficient market hypothesis (EMH) states that:
¾ “security prices fully reflect all available information”
o "available to the market /public" means that it must be accessible to all
o This is a very strong hypothesis as it refers to all information. It is therefore very hard easy to refute, as you only need to find one example.
¾ “security prices always equal fundamental value”
o fundamental to the market but not to insiders
Formally: E(Pt |fmt-1) = E(Pt |fmt-1, fat-1)
where E(Pt |fmt-1) = information set used by the market
E(Pt |fat-1) = specific information placed into the public domain.
It implies:
- there is no possibility that we can consistently make an abnormal return based on the publicly available information.
- if there is information put into the public domain that has not yet been used by the market and has not yet been reflected into the price, then there is an opportunity for investors to make an abnormal return (provided the transaction costs are smaller then the abnormal returns).
More CFA info & materials can be retrieved from the followings:
For visitors from Hong Kong: http://normancafe.uhome.net/StudyRoom.htm
For visitors outside Hong Kong: http://www.angelfire.com/nc3/normancafe/StudyRoom.htm
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Norman Cheung EMH