Efficient Market Hypothesis

A mathematical introduction and critical approach

Dominique Philipp Held Political Economy Ph.D. Tarron Khemraj December 2011

Table of Contents
1 Introduction ................................................................................................................ 1 2 Efficient Market Hypothesis ......................................................................................... 3 2.1 2.2 2.3 2.4 Short historical Summary .................................................................................. 3 Mathematical Description ................................................................................. 5 Different Forms................................................................................................ 10 Empirical evidence ........................................................................................... 12

3 Criticism of the EMH ................................................................................................. 15 3.1 3.2 Theoretical criticism ......................................................................................... 16 Empirical criticism ........................................................................................... 18

4 Bibliography ............................................................................................................... 20

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1 Introduction
There exists an old joke about an economist and his student. Strolling down a street, they come upon a $100 bill lying on the ground, and as the student reaches down to pick it up, the economist says, Dont botherif it were a genuine $100 bill, someone would have already picked it up. (Lo 1997, xi) This story emphasizes that the accurate efficiency of market according to the efficient market hypothesis (EMH). Market can be efficient even if there are errors in evaluation; even if there are market participants acting irrational; even if there are price fluctuations that cant be explained by current market information; and even if the market allocation itself is not efficient. Economics, referring to the EMH, basically state that once information arises, the news is spread around the market in almost no time. The prices then instantly incorporate the fact and move accordingly. But there are shades and gradations to what extend information may contribute to the price-setting mechanism. Uncompromising believes assume that all information, publicly and privately available, influence prices, whereas more moderate views only consider widely accessible, historical information is relevant. But all the considerations can only be assumed when there are a large number of rational profit-maximizing personal agents, who are actively competing against each other and constantly reviewing available information. Also this information has to be freely available to all the participants. The constant processing of new information assures that a price for a security is never under- or overvalued; it always represents the actual value.
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Further more prices do not depend on their past development. Consequently neither technical analysis, the examination of past stock price development, nor fundamental (intrinsic value method) analysis, the investigation in financial information, can predict any future trends. This implies that, on a long-term scale, an investor cant attain returns greater than the returns on a randomly selected portfolio; there are no $100 bills lying around ready to be picked up or if so they are not real. The only way to outperform the market is to take additional risk that lies above the average market risk. Widely accepted in theory, the hypothesis is criticized in practical application. There are very few markets, where the EMH can be applied with respect to its assumptions. Above all the security market is consider to be a market that comes closest to be seen as efficient thus a lot of thoughts have been tested and theories been verified here. Major concerns of testing EMH are the types of information relevant to incorporate into market price determination, the way in which this data is integrated and the velocity of it merging into the markets. Closely connected to the Efficient Market Hypothesis are the Random Walk Hypothesis (RWH) and the Martingale Model, which represent another way of stating that security prices move randomly and are not predictable, especially not in the short-term. But the hypotheses are distinct and one is neither necessary nor sufficient for the other.

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2 Efficient Market Hypothesis

Since the consideration of the efficient markets in the early 1970s the EMH always preserved one contradictory: the more efficient markets are, the more random they are. The most efficient markets are those where prices move absolutely unpredictable.

2.1 Short historical Summary

The hypothesis has its roots in the works of Samuelson and Mandelbrot, where they describe in his articles that prices in informationally efficient markets change unforecastalbe, if they are properly anticipated (Samuelson 1965), (Mandelbrot 1965). The market participants then thoroughly incorporate their expectations and information in the market prices because they want to profit form information advantages. This lead to the famous statement that that security prices at any time fully reflect all available information. A market in which prices always fully reflect available information is called efficient. (Fama 1970, 383). However this only holds when the market is considered to be frictionless and bears no transaction costs on its participants, so that no profits can be garnered from information-based trading. LeRoy and Lucas, as well, account for the EMH but pointed out that the RWH (and the Martingale Model) need not to be satisfied even if markets are efficient (LeRoy 1973), (Lucas 1978). Thus returns are not completely random in efficient markets. Furthermore Grossman and Stiglitz argued that perfectly efficient markets are impossible (Grossmann und Stiglitz 1980). The efficient market is more an idealization of real world markets, like a perfectly efficient engine is an idealization of a realistic piston engine.

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Nevertheless this gives economist the chance to compute a markets relative efficiency. These evaluated benchmarks can then be compared between different markets. But in efficient markets, the return of gathering information is zero and there are no incentives to trade based on information. Such markets would collapse. Inefficiency indicates the effort of investors to gather information and use them to realize market profits. Thus inefficiency compensates traders. The economic rents are generated, according to Black, by noise traders who trade not on actual information but merely noise, which they interpret incorrectly as valuable information (Black 1986). In a more recent work Malkiel pointed out that efficient markets do not allow investors to earn above-average profits without taking an aboveaverage risk (Malkiel 2003). But, in general, investors do not always react properly to the new gathered or disseminated information. They might be an overreaction or an underreaction. Prices that are then overvalued (undervalued) above (below) their fair or rational level will be soon balanced by other investors who are attracted (repelled) by the higher (lower) prices, thus converging the price levels against their normal level. Another approach to explain consistent above-average profits are competitive advantages. In an efficient market it is not possible to gain excess profit without a competitive advantage, such as superior information, superior technology or financial innovation. The profit above the market average is represented by the economic rent on the competitive advantage. Through that means a company can earn excess return by a technology breakthrough for a certain amount of time. After competitors have surmounted entry

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barriers (e.g. patents or market dominance) the profit returns to the market average. Certainly in financial markets these barriers are typically lower than in other markets. This is another evidence that the security market is considered as one of the most efficient.

2.2 Mathematical Description

To further describe the EMH it is necessary to specify the term fully reflected information. This can be achieved by assuming that the expected return of a security is a function of its risk: (!,!!! ! ) = 1 + (!,!!! ! ) !,! , where E is the expected value operator, pi,t is the price of security i at time t or t+1, ri,t+1 is the percentage return after one period (!,!!! !,! )/!,! , ! is the set of information that is assumed to be fully reflected and the tildes represents random variables at t. The expected return (!,!!! ! ) depends on a particular expected return theory, which proves or falls independently of the EMH and usually must be tested separately. Here we will use the expected-returns model (as suggested by (Fama 1970)) that can be expressed by the following equations: !,!!! = !,!!! (!,!!! ! ), with (!,!!! ! ) = 0, (1)

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where Zi,t+1, the unexpected (or excess) return, is difference between the observed return ri,t+1 and the expected return based on the information set ! . The expected value operator states that the average excess return is zero and Zi,t+1 becomes ri,t+1. Furthermore in equation (1) we use the capital asset pricing model (CAPM), according to Sharpe, Lintner and Mossin, to determine the expected returns: (! , ! ) , ! (! ) (2)

(! ) = ! + (! ) !

where (! ) is the expected return of security i, rf is the return of a riskless asset, (! ) is the expected return of a market portfolio and cov and ! are covariance and variance, respectively (Sharpe 1964), (Lintner 1965), (Mossin 1966). All the returns and (co)variance are considered in period t (single-period model). Equation (2) tells us that the only source of excess return is specified by the risk coefficient: (!,! , !,! ) . ! (!,! )

! =

This risk coefficient consists of the ratio of the covariance of a certain security return and a market return and the variance of the market return. Thus when both returns move together the risk coefficient will be positive, and vice versa; the stronger the covariability, the larger the risk coefficient. This model permits to quantify the trade-off between risk and expected return and shows a linear relationship to the risk coefficient. But there are several assumptions that have to be fulfilled:

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1. Investors have to be risk-avers, expected utility-maximizers (for end-of-period) who select their security portfolio based on statistical evidence (namely expected value and variance) regarding to the current period. 2. Perfect capital market; that is, investors are price takers. Also there are no taxes and transactions costs and all investors have the same access to gratuitous information 3. The quantities of securities are fixed. 4. Throughout the market there exists a general agreement on expected values, variances and covariances of the return of all securities. 5. There exists a riskless asset and investors can borrow and lend unlimited amounts at the riskless rate rf. To evaluate i usually the adjusted excess-return market model, originally proposed by Markowitz and extended by Sharpe and Fama, is used: ! = ! + ! ! + ! , (3)

where zi and zm are the excess returns for an asset i and a market portfolio, i and i are intercept and slope respectively, of the linear relationship and i is the individualistic factor representing the part of security is return independent of ! (Markowitz 1959), (Sharpe 1963), (Fama 1968). This portion has, in accordance to the EMH, the following properties: (! ) = 0, (! , ! ) = 0, (! , ! ) = 0. To compute the ordinary least square regression is

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applied. Note that the general excess-return market factor in equation (3) reflects general market and economic conditions related to a particular security i, not to a market portfolio. The assumptions that have to be fulfilled for the CAPM limit this model radically to application on real markets. Statements (1) (3) can generally be considered as acceptable and Lintner showed that removing assumption (4) does not change the structure of the model in a meaningful way (Lintner 1965). But supposition (5) is not a very good approximation of real markets. Studies by Black, Jensen and Scholes in (Jensen 1972) suggested that a two-factor model approximates the risk-return relationship better: (! ) = (! ) + (! ) (! ) ! , where (! ) is the expected return on a portfolio that has zero covariance with the return of the market portfolio rm (! = 0). In a more recent research the model is extended to a three-factor model, developed by Fama and French, which introduces a new factor involving the difference between the returns on diversified portfolios of small and big stocks and the difference between return on diversified portfolios of stocks with a high and low ratio of the book value to its market value (Fama und French 1993), (Fama und French 1996) . So far we have just dealt with one security but usually an investor has to possibility to invest freely in all the securities available in an economy. To extend our view coherently, consider the trading system: (! ) = ! (! ) + ! (! ) + + ! (! ),

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which shows an investor the values ! (! ) of available funds in period t that can be invested in each of the n securities. Then the total excess return in period t+1 produced by such a system is:
!

!!! =
!!! !

! (! ) !,!!!

!!! =
!!!

! (! ) !,!!! (!,!!! ! )

Again as seen above the expectation value of this total excess return !!! is: (!!! ! ) =
! !!! ! (! )(!,!!!

! ) = 0.

Before we continue I briefly want to summarize what we have achieved so far. We first lined out, in order to show how information is fully reflected, that the expected return of a security is a function of its risk. Then we moved on to the expected-returns model and found out that the expected value of an excess return is zero. In order to calculate these expected returns we used the CAPM, where we used the excess-return market model to evaluate the risk factor. Additionally we found further developments of this model to make it more applicable to real markets. Finally we extended our view from one security to the whole market. Although some models to measure risk have been presented, these are by far not the only methods to compute the relationship between risk and return.

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2.3 Different Forms

So far we have just covered an imprecise specification about what information is incorporated in the prices. Now we want to stipulate the news that is fully reflected. The information, which is fully reflected in prices, can be divided into three categories. These categories evolved mainly from testing the EMH and are initially developed by Fama (Fama 1970). Weak Form: The weak form of the EMH asserts that prices fully incorporate information contained in the past development. When future and present prices movements cannot be predicted upon past movements, there is no way to (consistently) outperform the market based on information garnered by the past. It also implies that no form of technical analysis (e.g. charting) used to select a portfolio can create an excess return above the required profit to compensate the higher risk level, effort of analysis and transaction costs. However, any market is not able to meet all the prerequisites of even the weak form of the EMH, so that only the degree to which markets are efficient (in view of the applied set of information) can be measured. This form of the EMH is expressed by the random-walk hypothesis. The weak form of the EMH is accomplished (for the security market) when security prices follow a random walk. It implies that todays price changes are completely independent of all prior prices in all respect. Though the weak form of the EMH does not implies all features of the RWH. Rather it just requires the expected value of present price changes to be fully independent of all past prices. Therefore evidence, which contradicts the random walk

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behavior, does not necessarily contradict the EMH. But evidence that supports the RWH does support the EMH. Semi-Strong Form: Under the semi-strong form of EMH we understand that prices incoporate all the information that is publicly available. Of course this also covers the development of past prices. So it includes the weak form as well. In other words, it is impossible, based on publicly accessible information, for an investor to earn an excess return over the average return commensurate with the portfolio risk. Instantaneously after economically relevant information has been disclosed the security price will adjust in no time and thus eliminating any chance to make excess profit. Although there might be a sharp price change on the announcement of the news, the semi-strong form prevents any discernible price reaction following the publication, because market participants would correct market prices immediately and in an unbiased manner. Strong Form: Finally the strongest form of the EMH states that all information will be impounded in security prices. Such an efficient market would always reflect all relevant information, regardless whether the information is publicly or privately available. Therefore any information disclosure would have no effect on security prices, because all information is already incorporated in the current price level. However, this news could affect the portfolio decision made by investors. It is very hard to test this kind of efficiency, because it is difficult

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to compute models that follow these information sets and there is little evidence so far that there is any market where the strong form of the EMH holds.

2.4 Empirical evidence

There are two predictions of the EMH about security prices. First, prices should respond quickly and correctly to news. That means that that market participants, who receive information late should not be able to profit from this information and that any price adjustment is accurate on average, there is no over- or undervalued reaction. Second, prices should not react without news concerning their securities, meaning that prices should not react to changes in demand or supply that are not accompanied by information dissemination about its fundamental value. Fama defined different forms of stale information that assures that investors cannot achieve above average profits (see section 2.3). However, it is both difficult and controversial to define what earning above average profits means. Section 2.2 gave some widely used models to measure the risk/return relationship. EMH proponents answer to criticism of the EMH has often been a shift to another model of risk that would attribute excess profit to a higher risk-taking. The weak form of the EMH has been broadly tested and the evidence that has been found is largely supportive. First evidence occurred in 1965 by Fama, who found out that stock prices indeed approximately follow random walks (Fama 1965). He discovered no systematic evidence of profitability of trading according to the technical analysis strategies. Stock prices are moving haphazardly without any influence of their previous development.

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To find evidence to corroborate the semi-strong version of the EMH is usually attempted with the use of event studies. In such an investigation economists look at particular news events pertaining to individual companies and then ask whether process adjusted to this information immediately or over a certain amount of time (usually a few days). Examples of this information can be earnings or dividends announcements, takeover and divestitures, share issues and repurchases, changes in management and so on. These events are evaluated empirically through the effects of the news on the security prices. If a favorable event is not anticipated by the market, the outcome of its announcement in an efficient market is a sharp upward adjustment of its price. On the other side, in an inefficient market, there would be an upward drift after the disclosure (see Figure 1).

Figure 1. Market reaction to an unanticipated favorable event1

This form of event studies has been constructed and improved by Fama, Fischer, Jensen and Roll (Fama, Fischer, et al. 1969). It quickly earned itself the nickname FFJR study. When an event is anticipated, then there is an ascendant trend before its dissemination, but when it

Source: Nikolai Chuvakhin, Efficient Market Hypothesis And Behavioral Finance Is A Compromise In Sight? in ncbase.com, http://ncbase.com/display.php?id=papers (accessed December 7, 2011), figure 3.

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is publically known the news is fully incorporated for the efficient market. Whereas, for the inefficient market the upward float continues after the information became known (see Figure 2).

Figure 2. Market reaction to an anticipated favorable event2

A huge number of studies showed supportive evidence for the weak and semi-strong form of the EMH. They illustrated that new information is quickly and accurately incorporated in prices of securities. For the second implication, namely that prices do not react to noninformation, Scholes provided supportive evidence studying share price reactions to sales of large blocks of shares in individual companies by substantial stockholders (Scholes 1972). He found relative small share price reactions to block sales and accounts for these reactions by the possible, but small, adverse news revealed by the decision of large blockholders to sell their shares. Closely related to this reasoning is the arbitrage argument of the EMH. When a seller unloads a block of shares on the market, other investors would gladly increase their holding of that stock a bit in exchange for only a trivial, if any, price concession. Then they

Source: Nikolai Chuvakhin, Efficient Market Hypothesis And Behavioral Finance Is A Compromise In Sight? in ncbase.com, http://ncbase.com/display.php?id=papers (accessed December 7, 2011), figure 4.

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would perhaps reduce their holdings of substitutes for that stock to keep the risk of their portfolio constant and competition between these potential buyers assures that the price concession for the uninformed seller is small. Thus the prices are not affected by large block sales of a stock. Arbitrageurs assure that prices fully reflect all information by taking prices that are out of line and return them to their natural level. So ultimately, the theoretical case for efficient markets depends on the effectiveness of arbitrage. Finally, there is little evidence that support the strong form of the EMH and the researches that have been done so far show implication that this version does not hold for security markets. These empirical tests have concentrated on the profitability of inside trading and Jaffe found that inside trader do earn excessive profits (Jaffe 1974). Furthermore Rozzef and Zaman provided evidence that inside trading produces an above average profit, which they calculated as 3% per year (after an assumed 2% transaction cost) (Rozeff und Zaman 1988).

3 Criticism of the EMH

In 1978 Jensen pronounced there is no other proposition in economics which has more solid evidence supporting it than the Efficient Market Hypothesis (Jensen 1978, 95). Shortly after this announcement the EMH was challenged both on theoretical and empirical grounds. What follows is a summary of the principal challenges.

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3.1 Theoretical criticism

First of all, it is difficult to sustain that people in general, and investors in particular, are perfectly rational agents. Many investors react to irrelevant information in forming their demand for securities. Black named this phenomenon noise trading (Black 1986). In reality, people hardly follow the passive strategies that are required for uninformed market participants for the EMH. They might sell winning stocks, hold on to the loosing ones, participate in actively managed mutual funds, listen and act to the advice of financial gurus and maybe fail to diversify their portfolio. People, who do not follow the normative economic model, can be divided into three different areas. First, individuals have a lossaversion. They tend to consider not the levels of final wealth they can attain but the relative gains and losses to some reference point, which is unique to every situation. This leads to inefficient portfolio decision, such as the notorious reluctance of investors to sell stocks that lose value. Second, individuals constantly violate maxims of probability in their predictions of uncertain outcomes. They often predict future uncertain events by taking a short development of past data try to approximate future trends based on this data. Thus, they are misled by the resulting model, but they do not give consideration to the fact that recent history is generated by chance rather then by the model they constructed. These heuristic reactions may lead investors astray. Third, people are reacting differently to choices depending on how they are presented. As Benartzi and Thaler found out, investors allocate more of their wealth to stocks rather than bonds when they see a very impressive history of long-term stock return relative to those on bonds, than if they only see the volatile shortterm stock returns (Benartzi und Thaler 1995). However, the EMH does not rely entirely on
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the rationality of market participants. The hypothesis states that there might exist traders, who act irrational, but their errors are random. So, taking the average value, all traders act rationally and their blunder cancels out. These problems, referred to as investor sentiment, are the common judgment errors may by a substantial number of investors; there are not the uncorrelated random mistakes. In the same way as individuals make irrational decisions, professional managers of pension or mutual funds and corporations are affected by irrational action. Another important argument against the EMH, described in the theory of behavioral finance, is that real-world arbitrage is risky and therefore limited. It is crucial for arbitrageurs to find a substitute for a security that is potentially affected by noise trading. They must be able, in order to lay of their risks, to buy a similar security that is not overpriced. But most of them have no equivalent substitute. Therefore, if substitute securities are mispriced, there is no riskless hedge for the arbitrageur. He cannot buy a substitute portfolio, if he thinks that stocks are overpriced, because there exists no such portfolio. Thus the ability of arbitrage to bring prices back into line is limited. But even if there is a perfect substitute for a security, an arbitrageur can still be faced with risk because of the possibility of future worse mispricing. Even if a security and its substitutes price converge with a probability of one, the trade may lead to temporary losses. Although there is a positive outcome, arbitrageurs may not maintain their position. DeLong et al. dubbed this risk as noise trader risk (DeLong, et al. 1990). Without the market-clearing factor of arbitrage an overvaluation or undervaluation of stock can maintain, which violates the EMH.

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3.2 Empirical criticism

Early empirical evidence against the weak form of the EMH has been found in studies concerning extreme looser and extreme winner portfolios. De Bondt and Thaler studied the best and the worst performing portfolios within three years and then computed the return of these portfolios over the next five years (De Bondt und Thaler 1985). They concluded, since the return could not be explained with standard risk adjustment, that there was an overreaction. Extreme losers became too cheap and bounced back, on average, over the subsequent period, and vice versa. Such long-term momentum stands in contradiction to the random walk hypothesis and the accurate incorporation of new information. Succeeding research also gave evidence of a short-term momentum that unlike the long-term momentum, which tends to reverse itself, continues over longer trends (Jegadeesh und Titman 1993). Criticism against the semi-strong form of the EMH can be drawn from the different evaluation of the scope of stocks. Siegel presented evidence that small stocks have earned higher return than large stocks (Siegel 2002). Surprisingly, the superior return has been concentrated on the January of each year. This abnormality shows, in contrast to the semistrong version, that stale information can be used to create excess returns. However, this may not be a failure of the EMH but of the underlying features of the risk-return model. Another approach to refute the semi-strong form is based on value-versus-growth studies. Firms with high market-to-book ratios are relatively the most expensive (growth) firms, whereas firms with a low ratio are the cheap (value) firms. Several studies showed that high

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market-to-book ratios reflect excessive market optimism about future profitability based on overreaction of past good news and present that they have sharply earned lower return than firms with low ratios. As an amendment to these studies, Fama and French developed their three-factor model (see section 2.2). To prove that stock prices do move also to non-information, another controversy to the EMH, researchers often argue that during a crash prices plummet without any news providing new information. Often the stock crash of 1978 is used because though there was intensive search for news that may have caused the crash no evidence was found. Culter, Poterba and Summers analyzed the 50 largest one-day stock price movements in the United States after World War II and found out that for most of them, there was no announcement (Cutler, Poterba und Summers 1991). All these conclusions heavily attack the foundations of the EMH and though some of the presented challenges against the hypothesis could be defended, there still exists serious doubt. However, this criticism is seen controversial and has to survive the test of time. So far the EMH still is the best description in security markets.

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4 Bibliography
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Jegadeesh, Narasimhan, and Sheridan Titman. "Returns to Buying Winners and Selling Losers: Implications for Stock Amrket Efficiency." Journal of Finance 48, no. 1 (March 1993): 65-91. Jensen, Michael C. "Some anomalous evidence regarding market efficiency." Journal of Financial Economics 6, no. 2-3 (June 1978): 95-101. . Studies in the Theory of Capital Markets,. New York: Praeger Publishers, 1972. LeRoy, Stephen. "Risk aversion and the martingale property of stock returns." International Economic Review 14, no. 2 (June 1973): 436-446. Lintner, John. "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets ." The Review of Economics and Statistics 47, no. 1 (Februar 1965): 13-37. Lo, Andrew W. Market Efficiency: Stock Market Behaviour in Theory and Practice. Vol. I. Cheltenham: Edward Elgar Publishing Limited, 1997. Lucas, Robert E., Jr. "Asset Prices in an Exchange Economy." Econometrica 46, no. 6 (November 1978): 1429-1445. Malkiel, Burton G. "The Efficient Market Hypothesis and Its Critics ." Journal of Economic Perspectives 17, no. 1 (Winter 2003): 59-82. Mandelbrot, Benot B. "Forecasts of Future Prices, Unbiased Markets, and "Martingale" Models." The Journal of Business 39, no. 1 (1965): 242-255. Markowitz, Harry M. Portfolio Selection: Efficient Diversification of Investments. 2nd Edition. Cambridge, Mass.: Blackwell Publishers, 1959. Mossin, Jan. "Equilibrium in a Capital Asset Market." Econometrica 34, no. 4 (October 1966): 768-783. Rozeff, Michael S., and Mir A. Zaman. "Market Efficiency and Insider Trading: New Evidence." The Journal of Business 61, no. 1 (January 1988): 25-44. Samuelson, Paul A. "Proof That Properly Anticipated Prices Fluctuate Randomly." Industrial Management Review 6, no. 2 (Spring 1965): 41. Scholes, Myron S. "The Market for Securities: Substitution Versus Price Pressure and the Effects of Information on Share Prices ." The Journal of Business 45, no. 2 (April 1972): 179211.

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Sharpe, William F. "A Simplified Model for Portfolio Analysis." Management Science 9, no. 2 (January 1963): 277-293. Sharpe, William F. "Capital asset prices: a theory of market equilibrium under conditions of risk." Journal of Finance 19, no. 3 (September 1964): 425-452. Siegel, Jeremy J. Stocks For The Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. Third Edition. New York: McGraw Hill, 2002.

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