Transcript Notes

Market efficiency
Kevin C.H. Chiang
Efficient market

(Informationally) efficient market: a market in
which security prices adjust fully and rapidly
to the arrival of new information and,
therefore, the current prices of securities fully
reflect all available information about the
security.
3 sufficient conditions for an efficient
market (Fama)



A large number of competing profitmaximizing participants analyze and value
securities, each “independent” of the others.
New information comes in a “random”
fashion.
The competing investors attempt to adjust
security prices rapidly to reflect the effect of
new information.
3 forms of market efficiency, I

Weak form: prices reflect all information
contained in the history of past trading.
Question: do past returns and prices predict
future returns?
3 forms of market efficiency, II

Semi-strong form: prices reflect all publicly
available information (earnings, dividends,
PE ratios, book-to-market ratios, political
news, etc.)
Question: how quickly do prices reflect all
public information?
3 forms of market efficiency, III

Strong form: prices reflect all relevant
information, including inside information.
Question: Do insiders make abnormal
returns?
Testing



Does a known strategy produce consistently
abnormal returns after adjusting for
investment risk and transaction costs?
No: the market is quite efficient.
Yes: evidence against the EMH.
Implications, I


In an efficient market, technical analysis is
useless.
In a semi-strong form efficient market,
fundamental analysts (country analysts,
industry analysts, and company analysts), on
average, will not outperform the market.
Implications, II


In a semi-strong form efficient market,
fundamental analysis is useless.
In this market, a portfolio manager should:
(1) determine a proper level of risk tolerance,
(2) form a portfolio consisting of the risk-free
asset and a well-diversified risky portfolio
(passive management), and (3) minimize
taxes and total transaction costs.
Passive management



No attempt to find undervalued securities.
No attempt to time.
Hold a well-diversified portfolio.
Active management/selection



Believe that one can beat the market.
Find undervalued securities.
Time the market.