CHAPTER 5
EFFICIENT CAPITAL MARKETS
I. Why Should Capital Markets Be Efficient?
A. Assumptions
1. Numerous profit maximizing participants
B. Thus, security prices at any point in time are an unbiased reflection of all available
information including the risk involved in owning the security
II. Alternative Efficient Market Hypotheses
A. Random Walk Hypothesis – changes in security prices occur randomly
B. Fair Game Model – current market price reflect all available information about a security
III. Tests and Results of Alternative Efficient Market Hypotheses
A. Weak Form Hypothesis: Tests and Results
1. Statistical Tests of Independence
2. Tests of Trading Rules
a. Potential pitfalls
3. Results of Simulations of Specific Trading Rules
a. Filter rules – an investor trades a stock when the price change exceeds a filter
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B. Semistrong-Form Hypothesis: Tests and Results
1. Two Sets of Studies
a. Time-series analysis of returns or the cross-section distribution of returns for
2. Adjustment for Market Effects – for any of these tests, the security’s rates of return
must be adjusted for the rates of return of the overall market during the period
considered
3. Results of Return Prediction Studies
a. Time series analysis
4. Predicting Cross-Sectional Returns
a. Price-Earnings Ratios and Returns
5. Results of Event Studies
a. Stock Split Studies
6. Summary on the Semistrong-Form EMH
C. Strong-Form Hypothesis: Tests and Results
1. Tests whether any group can consistently enjoy abnormal returns
2. Major Groups of Investors
a. Corporate Insider Trading
3. Conclusion Regarding the Strong-Form EMH – There appears to be mixed support
for the strong-form EMH as applied to most investors.
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IV. Behavioural Finance
A. It is concerned with the analysis of various psychological traits of individuals and how
these traits affect the manner in which they act as investors, analysts, and portfolio
managers
D. Insights from Behavioural Finance
1. Growth companies will usually not be growth stocks due to the overconfidence of analysts
regarding future growth rates and valuations
V. Implications of Efficient Capital Markets
A. Efficient Markets and Technical Analysis
1. The assumptions of technical analysis contradicts the Weak-Form of the Efficient
Market Hypothesis
B. Efficient Markets and Fundamental Analysis
1. Aggregate Market Analysis with Efficient Capital Markets
C. Efficient Markets and Portfolio Management
1. Portfolio Managers with Superior Analysts – concentrate efforts in mid-cap and
small-cap stocks that possess the liquidity required by institutional portfolio managers
2. Portfolio Managers without Superior Analysts
a. Determine and quantify your client’s risk preferences