Efficient Market Hypothesis EMH Presented by Inderpal Singh

Efficient Market Hypothesis (EMH) Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment Presented by Inderpal Singh

‘ As per EMH stock price at anytime equal to its intrinsic value or fair price’ Hence EMH implies that consistently superior returns can not be earned over a long period of time. Since the market prices is the fair price of its equity at anytime is good to buy or sell. Presented by Inderpal Singh

EMH and Competition Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information Presented by Inderpal Singh

Maurice Kendall 1953 No predictable patterns in stock prices Prices seem to evolve randomly Stock prices should follow a random walk i.e. the price changes should be random and unpredictable Prices increase or decrease only in response to new information which is unpredictable Presented by Inderpal Singh

Does randomness in price changes imply market irrationality? Presented by Inderpal Singh

No, if the prices of stock determined rationally, then only the new information will cause them to change. In fact a random walk would always be the natural result of prices that always reflect full current knowledge. Indeed if the stock prices are predictable that shows market inefficiency. Presented by Inderpal Singh

To illustrate the concept of a random walk, consider the following example: You are given $100 to play a game. At the end of each week a coin is tossed. If it comes up heads, you win 3 percent of your investment; if it is tails, you lose 2.5 percent. Therefore, your capital at the end of first week is either $ or $97.5. At the end of the second week, the coin is tossed again. Now the possible outcomes are:

This process is a random walk with a positive drift of.25 percent per week.2 It is a random walk because successive changes in value are independent. That is, the odds each week are the same, regardless of the value at the start of the week or of the pattern of heads and tails in the previous weeks. Presented by Inderpal Singh

Versions of the EMH Weak Semi-strong Strong Presented by Inderpal Singh

Week Form Security prices reflect all past prices & volume information Tomorrow price can not be predicted on the basis of today’s or yesterday’ price information Successive price changes are statistically independent ( Random Walk Theory) Presented by Inderpal Singh

The weak-form efficient market hypothesis assumes that current security prices reflect all the information available in the market including the historical price data, total trading volume data, and rates of return. Since the hypothesis assumes that security prices already reflect past information, it implies that the future rates of return should not depend on historical data, but instead, they should be independent. Consequently, in order to gain from buying or selling their securities, investors should not base their decisions on technical analysis or the study of past rates of return. Presented by Inderpal Singh

Implication of weak form of Market efficiency Technical analysis is useless Security prices follow random walk How can you make profits in weak form of market efficiency Fundamental analysis can be used as we can predict prices on basis of past data but we can test the fundamentals of a co. Presented by Inderpal Singh

Test of weak form of market efficiency Return over short horizon Runs test Filter test Return over long horizon Presented by Inderpal Singh

Semi Strong Form Security prices reflects not only past prices and volume information but also all publicly available information (Financial and operating information) One cant outperform the market using any publicly available information Insider can make profit out of inside information Fundamental as well as technical analysis is useless. Presented by Inderpal Singh

Test of Semi – Strong Form Test based on event study methodology announcement effects of earnings, dividends, mergers, bonus issues, stock splits etc. Post earnings announcement, price drift- Ball & Brown (1968) showed that earnings surprise are slowly adjusted in stock prices but not immediately. Market anomalies- size effect, P/E effect, value effect or book to market ratio effect, neglected firm effect etc. Presented by Inderpal Singh

Strong Form The strongest version of market efficiency. It states all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor the advantage. Presented by Inderpal Singh

Implication of EMH Security prices anytime reflect their true intrinsic value/ fair price/ fundamental value No one can outperform the market on consistent basis over long term. However short term fluctuations/ adjustments may provide some gains to some of the investors. There is random walk in stock prices Technical and fundamental analysis are useless Best investment strategy is passive management- index funds, ETFs etc. Presented by Inderpal Singh

Role of portfolio management in efficient market There is a role for rational portfolio management even in efficient market Diversification to eliminate firm specific risk Tax consideration Suggesting portfolio as per investors risk profit Presented by Inderpal Singh