1. 1 The Capital Markets and Market Efficiency

2. 2 Role of the Capital Markets Definition Economic Function Continuous Pricing Function Fair Price Function

3. 3 Definition Capital markets trade securities with lives of more than one year

4. 4 Economic Function The economic function of capital markets facilitates the transfer of money from savers to borrowers –e.g., mortgages, Treasury bonds, corporate stocks and bonds

5. 5 Continuous Pricing Function The continuous pricing function of capital markets means prices are available moment by moment –Continuous prices are an advantage to investors –Investors are less confident in their ability to get a quick quotation for securities that do not trade often

6. 6 Fair Price Function The fair price function of capital markets means that an investor can trust the financial system –The function removes the fear of buying or selling at an unreasonable price –The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

7. 7 Concept of Efficiency

8. 8 Efficiency defined Informational efficiency is a measure of how quickly and accurately the market reacts to new information –If the market is informationally very efficient Security prices adjust rapidly and accurately to new information

9. 9 Efficient Market In an efficient market, –Market price is an unbiased estimate of the true value of the investment. Market Efficiency does not require that the market price be equal to true value at every point in time.

10. 10 Efficient Market Errors in the market price be unbiased implying that prices can be greater than or less than true value, as long as these deviations are random. Randomness implies that there is an equal chance that stocks are under or over valued at any point in time.

11. 11 Example of Efficiency

12. 12 Example of Inefficiency

13. 13 Weak Form Definition Charting Runs Test

14. 14 Definition The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past –The current price is a fair one that considers any information contained in the past price data –Charting techniques are of no use in predicting stock prices

15. 15 Charting People who study charts are technical analysts or chartists –Chartists look for patterns in a sequence of stock prices –Many chartists have a behavioral element

16. 16 Runs Test A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance –A run is an uninterrupted sequence of the same observation

17. 17 Semi-Strong Form The semi-strong form of the EMH states that security prices fully reflect all publicly available information –e.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

18. 18 Semi-Strong Form (cont’d) Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as: –Stock splits –Cash dividends –Stock dividends This means investors are seldom going to beat the market by analyzing public news

19. 19 Strong Form The strong form of the EMH states that security prices fully reflect all relevant public and private information This means even corporate insiders cannot make abnormal profits by using inside information about their company –Inside information is information not available to the general public

20. 20 Security Prices and Random Walks The unexpected portion of news follows a random walk –News arrives randomly and security prices adjust to the arrival of the news We cannot forecast specifics of the news very accurately

21. 21 Anomalies Definition Low PE Effect Low-Priced Stocks Small Firm and Neglected Firm Effect Market Overreaction January Effect

22. 22 Anomalies (cont’d) Day-of-the-Week Effect Turn-of-the Calendar Effect Persistence of Technical Analysis Chaos Theory

23. 23 Definition A financial anomaly refers to unexplained results that deviate from those expected under finance theory –Especially those related to the efficient market hypothesis

24. 24 Low PE Effect Stocks with low PE ratios provide higher returns than stocks with higher PEs Supported by several academic studies Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

25. 25 Low-Priced Stocks Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price There is an optimum trading range

26. 26 Market Overreaction The tendency for the market to overreact to extreme news –Investors may be able to predict systematic price reversals Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

27. 27 January Effect Stock returns are inexplicably high in January Small firms do better than large firms early in the year Especially pronounced for the first five trading days in January

28. 28 Day-of-the-Week Effect Mondays are historically bad days for the stock market Wednesday and Fridays are consistently good Tuesdays and Thursdays are a mixed bag

29. 29 Day-of-the-Week Effect (cont’d) Should not occur in an efficient market –Once a profitable trading opportunity is identified, it should disappear The day-of-the-week effect continues to persist

30. 30 Turn-of-the-Calendar Effect The bulk of the return comes from the last trading day of the month and the first few days of the following month For the rest of the month, the ups and downs approximately cancel out

31. 31 Persistence of Technical Analysis Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices Studies show the markets are efficient in the weak form Literature based on technical techniques continues to appear but should be useless

32. 32 Chaos Theory Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic Econophysics refers to the application of physics principles in the analysis of stock market behavior –e.g., an investment strategy based on studies of turbulence in wind tunnels

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