EMH Corporate Finance

Hailey College of Banking
and Finance
Instructor: Abdul Qadeer

[email protected]
03336487274
Just Crowed
Investors, as a group, can do no better

than the market, because collectively
they are the market. Most investors trail
the market because they are burdened
by commissions and fund expenses.
Jonathan Clements, the Wall Street Journal, June 17, 1997
Efficient Capital Market
An efficient capital market is a market that is

efficient in processing information.
We are talking about an informationally efficient
market, In other words, we mean that the market
quickly and correctly adjusts to new information.
In an informationally efficient market, the prices of
securities observed at any time are based on
correct evaluation of all information available at
that time.
Therefore,
in
an
efficient
market,
prices
immediately and fully reflect available information.
Professor Eugene Fama and

Efficient Capital Market
"In an efficient market, competition among the many

intelligent participants leads to a situation where, at
any point in time, actual prices of individual securities
already reflect the effects of information based both on
events that have already occurred and on events
which, as of now, the market expects to take place in
the future. In other words, in an efficient market at any
point in time the actual price of a security will be a
good estimate of its intrinsic value.
Fama, Eugene, "Random Walks in Stock Market Prices,

Financial Analysts Journal , 1965.

Concept that Stock price movements follow
Brownian Motion and are thus Random Walk
was presented in 1900 by Louis Bachillier in his
PhD Thesis at Sorbonne : Thorie de la
Speculation .
In 1905 Albert Einstien, INTRODUCED the
Brownian Motion in Gas Particles.
In 1906, Karl Pearson, argued that STOCK PRICES
FOLLOW RANDOM WALK
EMH and Capital Markets
The Efficient Markets Hypothesis (EMH) is

made up of three progressively stronger
forms:
Weak Form
Semi-strong Form
Strong Form
The Weak Form
The weak form of the EMH says that past prices, volume, and
other market statistics provide no information that can be
used to predict future prices.
If stock price changes are random, then past prices cannot be
used to forecast future prices.
Price changes should be random because it is information that
drives these changes, and information arrives randomly.
Prices should change very quickly and to the correct level
when new information arrives (see next slide).
This form of the EMH, if correct, repudiates technical analysis.
Most research supports the notion that the markets are weak
form efficient.
Technical Analysis
Technical Analysis using prices and volume information

to predict future price changes
TA assumes prices use predictable trend
the + trend line is there because firms invest in + NPV
projects on average
If the markets are efficient, will technical analysis

be able to consistently predict price changes?
Price Adjustment with New

Information
At 10AM EST, the U.S. Supreme Court refused to hear an appeal

from MSFT regarding its anti-trust case. The stock immediately
dropped. This example, one of hundreds available every day,
illustrates that prices adjust extremely rapidly to new information.
But, did the price adjust correctly? Only time will tell, but it does
seem that over the next hour the market is searching for the correct
level.
Notes: Each bar represents high, low, and close for one-minute. Each solid gridline represents the top of an hour, and each
dotted gridline represents a half-hour.
The Semi-strong Form of EMH

and Capita Markets
The semi-strong form says that prices fully reflect all

publicly available information and expectations
about the future.
This suggests that prices adjust very rapidly to new
information, and that old information cannot be
used to earn superior returns.
The semi-strong form, if correct, repudiates
fundamental analysis.
Most studies find that the markets are reasonably
efficient in this sense, but the evidence is somewhat
mixed.
Fundamental Analysis
Fundamental Analysis using economic and

accounting information to predict stock price
changes
Will fundamental analysis be able to
consistently predict price changes?
If the markets are only weak form efficient?
Fundamental Analysis CAN predict price changes
If the markets are semi-strong or strong form efficient?
Fundamental Analysis CANNOT predict price changes
Fundamental Analysis
Fundamental analysis assumes that

stock prices should be equal to the
discounted value (PV) of the expected future

cash flows the stock is expected to provide to
investors.
Fundamental analysis is thus the art of

identifying over- and undervalued securities
based on an analysis of the firm's future
prospects.
Fundamental
Analysis
Fundamental analysis varies in
technique but generally focuses on
forecasting the firm's future dividends
or earnings, discounting those future
cash flows by the required rate of
return (usually obtained from the
CAPM), and comparing the resulting
estimated price with the current stock
price.
Decision-Mispricing:
Undervalued / Overvalued
If Intrinsic Value is less than market value
If Intrinsic Value is greater than market value
The EMH
Graphically
All historical prices and
returns
In this diagram, the

circles represent the
amount of information
that each form of the
EMH includes.
Note that the weak form
covers the least amount
of information, and the
strong form covers all
information.
Also note that each
successive form includes
previous ones.
All the
information,
public and
private
Strong Form
Semi-Strong
Weak Form
All public information
Analysts
Performance
This chart from the Wall Street Journal, shows that when analysts issue
sell recommendations, those stocks frequently outperform those with
buy or hold ratings. If the professionals cant get it right, who can?
The Strong Form
The strong form says that prices fully reflect

all information, whether publicly available or
not.
Even the knowledge of material, non-public
information cannot be used to earn superior
results.
Most studies have found that the markets are
not efficient in this sense.
Do security prices accurately reflect

information?
Informational Efficiency
Are price changes consistently predictable
Efficiency centers on the idea that stock prices always reflect

information.
Efficient markets help investors to feel confident about the

accuracy of stock prices, and that stocks are fairly prices.
Random Price Changes
Why are price changes random?

In very competitive markets prices should react
to only NEW information
Flow of NEW information is random
Therefore, price changes are random
Idea that stock prices follow a Random Walk
Anomalies
Deviation from the what is said as standard or

expected
Anomalies are unexplained empirical results
that contradict the EMH:
The Size effect.
The Incredible January Effect.
Day of the Week (Monday Effect).
The Size Effect
Beginning in the early 1980s a number of

studies found that the stocks of small firms
typically outperform (on a risk-adjusted basis)
the stocks of large firms.
This is even true among the largecapitalization stocks within the S&P 500. The
smaller (but still large) stocks tend to
outperform the really large ones.
The Incredible
January Effect
Stock returns appear to be higher in January

than in other months of the year.
This may be related to the size effect since it
is mostly small firms that outperform in
January.
It may also be related to end of year tax
selling.
The Day of the

Week Effect
Based on daily stock prices from 1963 to 1985 Keim
found that returns are higher on Fridays and lower
on Mondays than should be expected.
This is partly due to the fact that Monday returns
actually reflect the entire Friday close to Monday
close time period (weekend plus Monday), rather
than just one day.
Moreover, after the stock market crash in 1987, this
effect disappeared completely and Monday became
the best performing day of the week between 1989
and 1998.
Summary of Tests of
the EMH
Weak form is supported, so technical analysis
cannot consistently outperform the market.
Semi-strong form is mostly supported , so
fundamental analysis cannot consistently
outperform the market.
Strong form is generally not supported. If you have
secret (insider) information, you CAN use it to
earn excess returns on a consistent basis.
Ultimately, most believe that the market is very
efficient, though not perfectly efficient. It is
unlikely that any system of analysis could
consistently and significantly beat the market
(adjusted for costs and risk) over the long run.
Implications of Efficiency for

Active or Passive
Management
Active Management
Security analysis
Timing strategies
Investment Newsletters
Passive Management
Buy and Hold portfolios
Assumes inefficiency,
use technical and/or
fundamental analysis
to pick securities
Consistent with
semi-strong
efficiency
Selected Mini Cases
Mini Case 1
If Markets are efficient, what should be the
correlation coefficient between stock returns for two
non overlapping time periods.
Zero, otherwise returns

from the prior period
could be used to predict
returns in the subsequent
period.
Mini Case 2
A successful firm like intel has consistently
generated large profits for years. Is this a
violations of the EMH?
No. Why?
Maybe due to a higher
risk?
Maybe due to constant
surprises beyond
expected surprise
earnings.
Mini Case 3
Prices of Stock before stock splits show on
average consistently positive abnormal returns. Is
this a violation of the EMH?
Not necessarily, Why?
It could indicate information leakage (=>

a violation of EMH) or it could indicate that
splits occur during price runups (=> still
consistent of EMH).
Mini Case 4
If the business cycle is predictable, and a stock
has a positive beta, the stocks returns also must
be predictable. Respond
No, Why?
You wont get + abnormal returns if the economic
cycle is predictable, the news will already be
incorporated in the stocks price.
Mini Case 5
You know that firm XYZ is very poorly run. On a
management scale of 1 (worst) to 10 (best), you
would give it a score of 3. The market consensus
evaluation is that the management score is only
2. Should you buy or sell the stock?
No, Why?
You wont get + abnormal returns if the economic
cycle is predictable, the news will already be
incorporated in the stocks price.
Is the Market Rational?

The Behavioralists view the market bubble of
the 90s as proof that investors are not
rational
Sharpe, a Rationalist supporter, could not
explain the market crash of 1987. He
described it as unusual. His mother later told
him, Fifteen years of education, three
advanced degrees and all you can say is Its
unusual?
CONCLUSIONS?
Even behavioralists assume the markets are efficient

when calculating cost of capital
Even EMH supporters admit they need people to try
to beat the markets to keep them efficient
Intermediate Investments F305
So, buy and hold,
diversify and control your costs!
37
Anomalies in Technical and

Fundamental Investing
Technical
Short-term positive correlations
Long-term negative correlations
Small Firms in January effect
Fundamental
Investing for value v. growth
Vishny and Lalinshock
Fama and French
Intermediate Investments F305
38

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Hailey College of Banking

Instructor: Abdul Qadeer

Investors, as a group, can do no better

Jonathan Clements, the Wall Street Journal, June 17, 1997

Efficient Capital Market

An efficient capital market is a market that is

Professor Eugene Fama and

"In an efficient market, competition among the many

Fama, Eugene, "Random Walks in Stock Market Prices,

EMH and Capital Markets

The Efficient Markets Hypothesis (EMH) is

The Weak Form

Technical Analysis using prices and volume information

If the markets are efficient, will technical analysis

Price Adjustment with New

At 10AM EST, the U.S. Supreme Court refused to hear an appeal

The Semi-strong Form of EMH

The semi-strong form says that prices fully reflect all

Fundamental Analysis using economic and

Fundamental analysis assumes that

discounted value (PV) of the expected future

Fundamental analysis is thus the art of

If Intrinsic Value is less than market value

If Intrinsic Value is greater than market value

In this diagram, the

All public information

The Strong Form

The strong form says that prices fully reflect

Do security prices accurately reflect

Efficiency centers on the idea that stock prices always reflect

Efficient markets help investors to feel confident about the

Random Price Changes

Why are price changes random?

Deviation from the what is said as standard or

The Size Effect

Beginning in the early 1980s a number of

Stock returns appear to be higher in January

The Day of the

Implications of Efficiency for

Selected Mini Cases

Zero, otherwise returns

Not necessarily, Why?

It could indicate information leakage (=>

Is the Market Rational?

Even behavioralists assume the markets are efficient

Anomalies in Technical and

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