Corporate Financial Management Term paper
On
MARKET EFFICIENY and its problems
SUBMITTED BY
JOEL . J (0409003)
KRISHNA VAZRAPU (0409005)
SARATH CHAND (0409011)
M.S.TEJASWEE (0409015)
RAVI TEJA REDDY.S (0409020)
CONTENTS
INTRODUCTION...........................................................................................................................3
INVESTMENT VERSUS FINANCING DECISIONS...................................................................3
EFFICIENT FINANCIAL MARKET/ MARKET EFFICENY......................................................4
HOW DOES A MARKET BECOME EFFICIENT?......................................................................4
IMPLICATIONS OF MARKET EFFICIENCY.............................................................................5
MARKET EFFICIENCY LEVELS................................................................................................5
MARKET EFFICIENCY TYPES...................................................................................................6
TESTING MARKET EFFICIENCY...............................................................................................7
EFFICIENT MARKET HYPOTHESIS (EMH).............................................................................7
RANDOM WALK THEORY.........................................................................................................8
THE EMH RESPONSE...................................................................................................................8
THE EFFECT OF EFFICIENCY: NON-PREDICTABILITY.......................................................9
ANAMOLIES: THE CHALLENGE TO EFFICIENCY………...……………...……..…………9
THE JANUARY EFFECT.........................................................................................................10
THE WEEKEND EFFECT........................................................................................................11
EFFICIENT MARKET: THE EVIDENCES................................................................................12
THE SIX LESSONS OF MARKET EFFICIENCY WITH EXAMPLES....................................12
CONCLUSION..............................................................................................................................17
REFERENCES:.............................................................................................................................18
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INTRODUCTION
Market efficiency in simple words can be defined as “The degree to which stock prices
reflect all available, relevant information”. Market efficiency has varying degrees: strong, semi-
strong, and weak. Stock prices in a perfectly efficient market reflect all available information.
These differing levels, however, suggest that the responsiveness of stock prices to relevant
information may vary. Market efficiency is directly or implicitly tested any time a study is
performed to identify stock price reactions to certain events such as dividend announcements,
earnings announcements stock splits, large block transactions, repurchase tender offers, and other
public announcements. Traditionally, event study methodology is used to evaluate the reaction of
the market to certain corporate events. These studies which are specific in nature are designed to
measure market efficiency at certain points in time and only in conjunction with specific events.
A more encompassing or macro evaluation of market efficiency can be made by testing whether
or not the returns in a market follow a random walk process over a longer period of time.
Financial theory predicts that stock prices should fluctuate randomly in the short run if the stock
market is efficient. The semi-strong form of the Efficient Market Hypothesis (EMH) holds that
the market instantaneously absorbs all relevant information as it becomes publicly available.
Hence, daily returns should fluctuate as random white noise.
INVESTMENT VERSUS FINANCING DECISIONS
Investment analysis is crucial to determining the maximum rate of return on investments
in order to make investment decisions. Financing decisions relate to raising of capital structure of
the company. Investment and financing decisions need to be made separately. If made separately,
new projects will be evaluated on a consistent basis. Profitability can be determined in a true
fashion. Financing and investment decisions are made by different departments and therefore
need to be considered separately. Benefits of special financing can be quantified and included in
the investment proposal. Different cash flows are rated differently in investment and financial
decisions, therefore different discount rates are used. Mixing these decisions will cause
improperly allocated resources.
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EFFICIENT FINANCIAL MARKET/ MARKET EFFICENY
In the 1970s Eugene Fama defined an efficient financial market as "one in which prices
always fully reflect available information”.
The most common type of efficiency referred to in financial markets is the allocative
efficiency, or the efficiency of allocating resources. In an efficient market no one could
outperform the market by using the same information that is already available to all investors,
except through luck. This includes producing the right goods for the right people at the right
price.
A trait of allocatively efficient financial market is that it channels funds from the ultimate
lenders to the ultimate borrowers in a way that the funds are used in the most socially useful
manner.
HOW DOES A MARKET BECOME EFFICIENT?
In order for a market to become efficient, investors must perceive that a market is
inefficient and possible to beat. Ironically, investment strategies intended to take advantage of
inefficiencies are actually the fuel that keeps a market efficient.
A market has to be large and liquid. Information has to be widely available in terms of
accessibility and cost and released to investors at more or less the same time. Transaction costs
have to be cheaper than the expected profits of an investment strategy. Investors must also have
enough funds to take advantage of inefficiency until, according to the EMH (Efficient Market
Hypotheses), it disappears again. Most importantly, an investor has to believe that she or he can
outperform the market.
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IMPLICATIONS OF MARKET EFFICIENCY:
The three important points that imply market efficiency are:-
(a) In an efficient market, equity research and valuation would be a costly task that provided no
benefits. The odds of finding an undervalued stock would always be 50:50, reflecting the
randomness of pricing errors. At best, the benefits from information collection and equity
research would cover the costs of doing the research.
(b) In an efficient market, a strategy of randomly diversifying across stocks or indexing to the
market, carrying little or no information cost and minimal execution costs, would be superior to
any other strategy, that created larger information and execution costs. There would be no value
added by portfolio managers and investment strategists.
(c) In an efficient market, a strategy of minimizing trading, i.e., creating a portfolio and not
trading unless cash was needed, would be superior to a strategy that required frequent trading.
MARKET EFFICIENCY LEVELS
They are identified at three levels:
1. Weak-form efficiency
Prices of the securities instantly and fully reflect all information of the past prices. This
means future price movements cannot be predicted by using past prices.
2. Semi-strong efficiency
Asset prices fully reflect all of the publicly available information. Therefore, only
investors with additional inside information could have advantage on the market.
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3. Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no
one can have advantage on the market in predicting prices since there is no data that would
provide any additional value to the investors.
MARKET EFFICIENCY TYPES
James Tobin identified four efficiency types that could be present in a financial market. They are
1. Information arbitrage efficiency
Asset prices fully reflect all of the privately available information (the least demanding
requirement for efficient market, since arbitrage includes realizable, risk free transactions)
Arbitrage involves taking advantage of price similarities of financial instruments between
2 or more markets by trading to generate losses.
It involves only risk-free transactions and the information used for trading is obtained at
no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that
arbitrage is a result of market inefficiency. This reflects the weak-information efficiency model.
2. Fundamental valuation efficiency
Asset prices reflect the expected past flows of payments associated with holding the
assets (profit forecasts are correct, they attract investors)
Fundamental valuation involves lower risks and less profit opportunities. It refers to the
accuracy of the predicted return on the investment.
Financial markets are characterized by predictability and inconsistent misalignments that
force the prices to always deviate from their fundamental valuations. This reflects the semi-
strong information efficiency model.
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3. Full insurance efficiency
It ensures the continuous delivery of goods and services in all contingencies.
4. Functional/Operational efficiency
The products and services available at the financial markets are provided for the least cost
and are directly useful to the participants.
TESTING MARKET EFFICIENCY
Tests of market efficiency look at the whether specific investment strategies earn excess
returns. Some tests also account for transactions costs and execution feasibility. Since an excess
return on an investment is the difference between the actual and expected return on that
investment, there is implicit in every test of market efficiency a model for this expected return. In
some cases, this expected return adjusts for risk using the capital asset pricing model or the
arbitrage pricing model, and in others the expected return is based upon returns on similar or
equivalent investments. In every case, a test of market efficiency is a joint test of market
efficiency and the efficacy of the model used for expected returns. When there is evidence of
excess returns in a test of market efficiency, it can indicate that markets are inefficient or that the
model used to compute expected returns is wrong or both. While this may seem to present an
insoluble dilemma, if the conclusions of the study are insensitive to different model
specifications, it is much more likely that the results are being driven by true market
inefficiencies and not just by model misspecifications
EFFICIENT MARKET HYPOTHESIS (EMH)
Eugene Fama in 1970 created the Efficient Market Hypothesis (EMH) theory, which
states that in any given time, the prices on the market already reflect all known information, and
also change fast to reflect new information.
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This means no one could outperform the market by using the same information that is
already available to all investors, except through luck.
However, this suggests that at any given time, prices fully reflect all available
information on a particular stock and/or market. Thus, according to the EMH, no investor has an
advantage in predicting a return on a stock price because no one has access to information not
available to everyone.
RANDOM WALK THEORY
Another theory related to the efficient market hypothesis created by Louis Bachelier is
the “random walk” theory, which states that the prices in the financial markets evolve randomly
and are not connected, they are independent of each other.
Therefore, identifying trends or patterns of price changes in a market couldn’t be used to
predict the future value of financial instruments.
THE EMH RESPONSE
The EMH does not dismiss the possibility of anomalies in the market that result in the
generation of superior profits. In fact, market efficiency does not require prices to be equal to fair
value all of the time. Prices may be over- or undervalued only in random occurrences, so they
eventually revert back to their mean values. As such, because the deviations from a stock's fair
price are in themselves random, investment strategies that result in beating the market cannot be
consistent phenomena.
Furthermore, the hypothesis argues that an investor who outperforms the market does so
not out of skill but out of luck. EMH followers say this is due to the laws of probability: at any
given time in a market with a large number of investors, some will outperform while other will
remain average.
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When money is put into the stock market, it is done with the aim of generating a return
on the capital invested. Many investors try not only to make a profitable return, but also to
outperform, or beat, the market.
Thus, according to the EMH, no investor has an advantage in predicting a return on a
stock price because no one has access to information not already available to everyone else.
THE EFFECT OF EFFICIENCY: NON-PREDICTABILITY
The nature of information does not have to be limited to financial news and research
alone; indeed, information about political, economic and social events, combined with how
investors perceive such information, whether true or rumored, will be reflected in the stock price.
According to EMH, as prices respond only to information available in the market, and, because
all market participants are privy to the same information, no one will have the ability to out-
profit anyone else.
In efficient markets, prices become not predictable but random, so no investment pattern
can be discerned. A planned approach to investment, therefore, cannot be successful.
This "random walk" of prices, commonly spoken about in the EMH school of thought,
results in the failure of any investment strategy that aims to beat the market consistently. In fact,
the EMH suggests that given the transaction costs involved in portfolio management, it would be
more profitable for an investor to put his or her money into an index fund.
ANOMALIES: THE CHALLENGE TO EFFICIENCY
In the real world of investment, however, there are obvious arguments against the EMH.
There are investors who have beaten the market - Warren Buffett, whose investment strategy
focuses on undervalued stocks, made millions and set an example for numerous followers. There
are portfolio managers who have better track records than others, and there are investment
houses with more renowned research analysis than others. So how can performance be random
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when people are clearly profiting from and beating the market?
Counter arguments to the EMH state that consistent patterns are present. Here are some
examples of some of the predictable anomalies thrown in the face of the EMH: the January
effect is a pattern that shows higher returns tend to be earned in the first month of the year; "blue
Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday
morning because of the weekend effect, the tendency for prices to be higher on the day before
and after the weekend than during the rest of the week.
Studies in behavioral finance, which look into the effects of investor psychology on stock
prices, also reveal that there are some predictable patterns in the stock market. Investors tend to
buy undervalued stocks and sell overvalued stocks and, in a market of many participants, the
result can be anything but efficient.
THE JANUARY EFFECT
Studies of returns in the United States and other major financial markets consistently
reveal strong differences in return behavior across the months of the year. Returns in January are
significantly higher than returns in any other month of the year. This phenomenon is called the
year-end or January effect, and it can be traced to the first two weeks in January.
The relationship between the January effect and the small firm effect adds to the
complexity of this phenomenon. The January effect is much more accentuated for small firms
than for larger firms, and roughly half of the small firm premium, described in the prior section,
is earned in the first two days of January. A number of explanations have been advanced for the
January effect, but few hold up to serious scrutiny. One is that there is tax loss selling by
investors at the end of the year on stocks which have 'lost money' to capture the capital gain,
driving prices down, presumably below true value, in December, and a buying back of the same
stocks in January, resulting in the high returns. The fact that the January effect is accentuated for
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stocks which have done worse over the prior year is offered as evidence for this explanation.
There are several pieces of evidence that contradict it, though.
First, there are countries, like Australia, which have a different tax year, but continue to
have a January effect. Second, the January effect is no greater, on average, in years following
bad years for the stock market, than in other years. A second rationale is that the January effect is
related to institutional trading behavior around the turn of the years. It has been noted, for
instance, that ratio of buys to sells for institutions drops significantly below average in the days
before the turn of the year and picks to above average in the months that follow. It is argued that
the absence of institutional buying pushes down prices in the days before the turn of the year and
pushes up prices in the days after.
THE WEEKEND EFFECT
The weekend effect is another return phenomenon that has persisted over extraordinary
long periods and over a number of international markets. It refers to the differences in returns
between Mondays and other days of the week. The returns on Mondays are significantly
negative, whereas the returns on every day of the week are not. There are a number of other
findings on the Monday effect that have fleshed out. First, the Monday effect is really a weekend
effect since the bulk of the negative returns is manifested in the Friday close to Monday open
returns. The returns from intraday returns on Monday are not the culprits in creating the negative
returns. Second, the Monday effect is worse for small stocks than for larger stocks. Third, the
Monday effect is no worse following three-day weekends than two-day weekends. There are
some who have argued that the weekend effect is the result of bad news being revealed after the
close of trading on Friday and during the weekend.
This reveals that more negative earnings reports are revealed after close of trading on
Friday. Even if this were a widespread phenomenon, the return behavior would be inconsistent
with a rational market, since rational investors would build in the expectation of the bad news
over the weekend into the price before the weekend, leading to an elimination of the weekend
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effect. The presence of a strong weekend effect in Japan, which allowed Saturday trading for a
portion of the period studies here indicates that there might be a more direct reason for negative
returns on Mondays than bad information over the weekend. As a final note, the negative returns
on Mondays cannot be just attributed to the absence of trading over the weekend. The returns on
days following trading holidays, in general, are characterized by positive, not negative, returns.
Paul Krugman, MIT economics professor, suggests that because of the mass mentality of
the trendy, short-term shareholder, investors pull in and out of the latest and hottest stocks. This
results in stock prices being distorted and the market being inefficient. So prices no longer reflect
all available information in the market. Prices are instead being manipulated by profit seekers.
EFFICIENT MARKET: THE EVIDENCES
Evidence of Financial Market Efficiency
Predicting future asset prices is not always accurate (represents weak efficiency form)
Asset prices always reflect all new available information quickly (represents semi-strong
efficiency form)
Investors can't outperform on the market often (represents strong efficiency form)
Evidence of Financial Market In-Efficiency
January effect (repeating and predictable price movements and patterns occur on the
market)
Stock market crashes
Investors that often outperform on the market such as Warren Buffet.
THE SIX LESSONS OF MARKET EFFICIENCY WITH EXAMPLES
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Capital markets function sufficiently well in the sense that opportunities for easy profits
are rare. These imply important implications for the financial manager.
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LESSON 1: MARKETS HAVE NO MEMORY
Market having no memory implies weak form of the efficiency hypothesis. i.e., the sequence of
past price changes contains no information about future changes.
Example of corporate financing
Managers’ Inclination:
a.)Favor equity rather than debt financing after an abnormal price rise and be reluctant to issue
stock after a fall in price.
b.)The idea is to catch the market while it is high and to wait for a rebound while it is low.
Lesson: Since the market has no memory, the cycles that financial managers seem to rely on do
not exist.
A Note: High stock prices in general market movement signal expanded investment
opportunities and the need to finance them. We would expect to see firms raise more money in
total when stock prices are historically high. But this does not explain why firms prefer to raise
the extra cash at these times by an issue of equity rather than debt.
LESSON 2: TRUST MARKET PRICES
Reason: In an efficient market, prices impound all available information about the value of each
security.
Implication: There is no way for most investors to achieve consistently superior rates of return.
Firm’s exchange-rate policy or its purchases and sales of debt:
The financial managers should not operate on the basis that they are smarter than others
at predicting currency changes or interest-rate moves. [Otherwise, they will trade a consistent
financial policy for an elusive will-o-the-wisp.]
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Example: Orange County’s losses in 1994
The county treasurer had raised large short-term loans (reverse repo) which he then used
to invest in long-term bonds (reverse floaters) and bet on a fall in interest rates. However,
interest rates subsequently rose and the county had lost $1.7 billion.
LESSON 3: READ THE ENTRAILS
Prices impound all the available information. This implies, if you can learn to read the
entrails, security prices can tell us a lot about the future.
Examples:
1) The market’s assessment of a firm’s bonds (besides the information in its financial
statements) can provide important information about estimating the probability of bankruptcy.
2) Differences between the long-term interest rate and the short-term rate tell you something
about what investors expect to happen to future short-term rates.
Illustration: Current long-term rate higher than the short-term rate. This implies that the future
short-term rates are rising.
Suppose that investors are confident that interest rates are set to rise over the next year
(i.e., future short-term rates will rise).
They will prefer to wait before they make long-term loans, and any firm that wants to
borrow long-term money today will have to offer the inducement of a higher rate of interest. In
other words, the long-term rate of interest will have to be higher than the one-year rate.
Practical Example: The merge of HP and Compaq.
On Sept. 3, 2001, the two firms announced the proposal to merge because of significant
cost structure improvements and access to new growth opportunities. [Note that these two types
of gains are the usual synergies related to a merger.]
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Over the following two days, HP shares underperformed the market by 21% and Compaq
shares underperformed by 16%. On Nov. 6, the Hewlett family announced that it would vote
against the proposal. Investors took heart that the next day HP shares gained 16%.
Note that the merger eventually proves to be successful later in 2003. [The reason could
be that management did have important information that investors lacked.] But the point is that
the price reaction of the two stocks provided a potentially valuable summary of investor opinion
about the effect of the merger on firm value.
LESSON 4: THERE ARE NO FINANCIAL ILLUSIONS
No Financial Illusions: In an efficient market, investors are unromantically concerned with the
firm’s cash flows and the portion of these cash flows to which they are entitled.
Example: Stock dividends and splits
Subdividing the existing shares or distributing more shares as dividends increases the
number of shares outstanding but does not affect the firm’s future cash flows or the proportion of
these cash flows attributable to each shareholder.
A Classic Study of Stock Splits by Fama Et. Al. (1969):
Price rises around the time of the split announcement (before the split takes place).
Implication: The decision to split is both the consequence of a rise in price and the cause of a
further rise. This implies, shareholders are not as hard-headed as we make out. They care about
the form as well as the substance.
Explanation: The study also found that during the subsequent year, two-thirds of the splitting
firms announced above-average increases in cash dividends. There was no unusual rise in the
stock price at any time after the split.
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This implies, the split was accompanied by an explicit or implicit promise of a dividend
increase and the rise in price at the time of the split had nothing to do with a taste for splits but
with the information that it was thought to convey.
A Note: The above-average increases in cash dividends imply that the splitting firms appears to
be unusually successful in other ways.
Asquith et. al. (1989) found that stock splits are frequently preceded by sharp increases in
earnings. Such earnings increases are very often transitory. However, the stock split appears to
provide investors with an assurance that in this case the rise in earnings is indeed permanent.
LESSON 5: THE DO-IT-YOURSELF ALTERNATIVE
The Alternative: In an efficient market, investors will not pay others for what they can do
equally well themselves.
Implication: Many of the controversies in corporate financing center on how well individuals
can replicate corporate financial decisions.
LESSON 6: SEEN ONE STOCK, SEEN THEM ALL
Perfect Substitutes: Investors don’t buy a stock for its unique qualities. They buy it because it
offers the prospect of a fair return for its risk. This implies, stocks should be like very similar
bands of coffee, almost perfect substitutes. Also, the demand for a firm’s stock should be highly
elastic. [If its expected return is low relative to its risk, nobody will want to hold that stock. If
the reverse is true, everybody will scramble to buy.]
Implications of Elastic Demand: You can sell large blocks of stock at close to the market price
as long as you can convince other investors that you have no bad private information.
Evidence:
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1) In June 1977, the Bank of England offered its holding of BP shares for sale at 845 pence. The
bank owned nearly 67 million shares of BP. The total value was about US$970 million.Just
before the Bank’s announcement, the price of BP stock was 912 pence. Over the next two-week
application period, the price drifted down to 898 pence. [Price almost didn’t change.] Thus, by
the final application date, the discount being offered was only 6%. But the discount brings in
applications for US$4.5 billion worth of stock, 4.7 times the amount on offer. [The demand is
indeed highly elastic.]
2) The study on secondary offerings by Scholes (1972) shows that the effect of the offerings was
a slight reduction in the stock price. But the decline was almost independent of the amount
offered. Estimate of the demand elasticity for a firm’s stock was -3,000.
3) Asquith and Mullins (1986) found that new stock issues by utilities drove down their stock
prices on average by only 0.9%.
CONCLUSION
Financial market efficiency is an important topic in the world of Finance. While most
financiers believe the markets are neither 100% efficient, nor 100% inefficient, many disagree
where on the efficiency line the world's markets fall. It can be concluded that in reality a
financial market can’t be considered to be extremely efficient, or completely inefficient. The
financial markets are a mixture of both, sometimes the market will provide fair returns on the
investment for everyone, while at other times certain investors will generate above average
returns on their investment. Ironically, thinking that the financial market is inefficient and that it
can be “beaten” is what is actually keeping the financial market functioning efficiently.
In other words, in the real world, markets cannot be absolutely efficient or wholly
inefficient. It might be reasonable to see markets as essentially a mixture of both, wherein daily
decisions and events cannot always be reflected immediately into a market. If all participants
were to believe that the market is efficient, no one would seek extraordinary profits, which is the
force that keeps the wheels of the market turning.
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In the age of information technology (IT), however, markets all over the world are
gaining greater efficiency. IT allows for a more effective, faster means to disseminate
information, and electronic trading allows for prices to adjust more quickly to news entering the
market. However, while the pace at which we receive information and make transactions
quickens, IT also restricts the time it takes to verify the information used to make a trade. Thus,
IT may inadvertently result in less efficiency if the quality of the information we use no longer
allows us to make profit-generating decisions.
REFERENCES:
PRINCIPLES OF CORPORATE FINANCE- RICHARD A BREALEY
FINANCIAL MANAGEMENT- PRASANNA CHANDRA
WWW.INVESTOPEDIA.COM
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