Market Efficiency - Finance - Lecture Slides, Slides of Finance

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Market Efficiency

Lecture Agenda

1. Importance of Market Efficiency

2. Definition of Market Efficiency

3. Efficient Market Hypothesis

4. Empirical Evidence

5. Implications

Importance Definition EMH^ Evidence Implications

Importance of Market Efficiency

The Importance of Market Efficiency

The If and How the EMH Principal can Affect Shareholder Wealth

• Understanding how securities are valued is important because

these valuation principles provide guidelines to managers how

they should manage businesses on behalf of the shareholders.

• It is the legal requirement and managerial responsibility for

managers to act in the owners’ best interest.

• The discount rate that represents shareholder’s required rate of

return is established as a result of benchmark rates in the capital

markets such as the Risk-Free Rate (RF) and the market risk

premium.

• A question remains…DO MARKET PRICES REFLECT THE ACTIONS

OF MANAGERS?

• If they do, then managers must learn what actions they should take in order to fulfill their legal and managerial responsibilities to shareholders.

Importance of Market Efficiency

Informational Efficiency

• Informational Efficiency is the focus of

this chapter.

• The closer the link between actions of

managers and the value of the firm, the

more informationally-efficient the

capital market.

Importance of Market Efficiency

Securities Laws Affecting Public-Issuers of Securities Securities laws in Canada reflect the belief that there is (or should be) a strong connection between information and stock prices and these laws reflect a number of common principles related to parties to transactions and access to information:

• Continuous disclosure of all material information about the firm.
  • Publicly-traded firms fulfill this responsibility through publication of annual audited financial statements, unaudited quarterly financial statements, and through timely press releases and announcements of anything that could ‘materially’ affect the share price of the firm.
• Fair and equal treatment of all market participants through disclosure requirements that ensure all participants have simultaneous access to the same information about publicly-traded firms. - The use of cease-trading orders when new information is being released to the market is an example of how regulators ensure that information is widely disseminated to all market participants before trading is allowed to occur. In this way, all market participants are trading on the basis of the same and complete information ensuring that some participants do not have an informational advantage over others.

Asymmetric Information

An Example – The Used Car!

An example of Asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private transaction.

• The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problems.
• The buyer (presuming no expertise as a mechanic) has only their limited skills of observation and investigation to inform their purchase decision.

In the foregoing example, it is possible, in the absence of rules and regulations, for the seller to take advantage of the buyer because of information asymmetry. This means, the buyer is likely to pay more for the car than they should! The seller reaps the rewards of superior information.

In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation. This package will include an estimate of wholesale and retail price of the used car, and a list of past owners. This is an example of government regulation to try to reduce the information advantage sellers have over buyers.

Disclosure and Market Efficiency

The Asymmetric Information Challenge

• If informational advantages were widely permitted, and if there were a persistent advantage of some market participants over others, the credibility of the markets would be shaken.
• Under such circumstances, many people would choose not to invest in securities, choosing, instead to put their money into managed deposits, or worse, choosing to hide their money under a pillow.
• This would significantly reduce the number of market participants, and the amounts of money invested in the markets.
• The result would be:
  • Less market efficiency – and even fewer willing participants!
  • Lower security prices in general
  • Infrequent trading of securities
  • Increasing ability of one market participant to affect the security price through their actions.
• Ultimately, the capital market would not be able to channel sufficient surplus funds to underwrite economic activity such as plant expansions, research and development, etc. In the end, companies would lack capital, and increasingly become inefficient and ineffective in their markets. Jobs would be lost and the standard of living of all would decline.

Defining Market Efficiency

What is an Efficient Market?

An Efficient Market …

• Is a market that reacts quickly and

relatively accurately to new public

information, which results in prices that

are correct, on average.

Market Efficiency

Requisite Conditions

For markets to operate efficiently some conditions must exist:

1. A large number of rational, profit-maximizing investors exist, who actively participate in the market by analyzing, valuing, and trading securities. The markets must be competitive, meaning no one investor can significantly affect the price of the security through their own buying or selling.
2. Information is costless and widely available to market participants at the same time.
3. Information arrives randomly and therefore announcements over time are not serially connected.
4. Investors react quickly and fully (and reasonably accurately) to the new information, which is reflected in stock prices.

Efficient Market Hypothesis (EMH)

Defined

The Efficient Market Hypothesis is

• The theory that markets are efficient

and therefore, in its strictest sense,

implies that prices accurately reflect all

available information at any given time.

Efficient Market Hypothesis (EMH)

Weak Form EMH

• The theory that security prices reflect all

market data, referring to all past price

and volume trading information.

• Implication:

– If Weak Form efficient, historical trading

data will already be reflected (discounted)

in current prices and should be of no value

in predicting future price changes.

Efficient Market Hypothesis (EMH)

Strong Form EMH

• The theory that stock prices fully reflect all

information, which includes both public

and private information.

• Implications:

– Stock prices are fairly priced.

– It is not possible to use public information to

identify over-priced or under-priced stocks

– It is not possible to use insider information to

identify over-priced or under-priced stocks

Empirical Tests of the EMH