Efficient Capital Markets - Literature review Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Course : xxxxxxxxxxx Title : Investment Analysis Tutor : xxxxxxxxxxx @2011 Investment Analysis Introduction A given economy’s capital stock allocation is handled by the capital market. Fama (1970) suggests that an ideal market is that which its prices give accurate signals that are needed for resource allocation. In other words it is a market that enables firms to form production investment decisions and also that which permits investors to select among securities that show the ownership of a firm’s activities. The selection is pegged on the assumption that the security prices at one given time “fully reflect” the available information and is as such referred to as “efficient.” According to Malkiel (2003) efficiency refers to a situation in which there are controls that do not permit investors to earn returns that are above average without taking on above average risks. Forms of Efficient Markets Hypothesis According to Fama (1970) security prices are based on three information subset tests of efficient markets hypothesis; weak form, semi-strong form and strong form. The weak form test is that one in which the information set comprises of a discussion on historical prices. The semi-strong test form is a check on whether security prices efficiently adjust to that of publicly available information. The publicly available information includes stock splits, security issues and annual earnings announcements. Lastly, the strong form test is concerned with whether different groups or investors (for instance management of various mutual funds) have monopolistic access to relevant information that pertains to price formation. Evidence on the theory of the three forms of the hypothesis Though Fama (1991) argues that there is efficient market hypothesis stands up very well to data, it is a null hypothesis that is to the extreme. Like a great number of available null hypothesis; it is not expected to be literally true. Efficient market hypothesis’s categorization into three forms allows it be dissected and examined so as to show its strength. It has therefore been proved that there is not vital evidence that dispute its semi-strong and weak form tests. There is not important evidence since prices efficiently adjust to information that is publicly available. On the other hand there is also limited evidence that is available against the hypothesis that exists in strong form tests (it is noted that monopoly is not prevalent in any particular investment community). Fama (1970) suggests that efficient markets theory is majorly concerned with whether or not prices at any given point “fully reflect” the available information. It is however only constituted of empirical content within a specific model context of a given market equilibrium. The market equilibrium is a model that outlines the market equilibrium nature in the event that prices “fully reflect” the information that is available. It has been noted that available empirical literature is explicitly or implicitly pegged on the assumption that market equilibrium conditions are able to be outlined in terms of the expected returns. The aforementioned assumption forms the basis of “fair game” or expected return efficient markets models. Fama (1991) categorises the empirical work of the theory into three depending on the information of interest subset’s nature. Strong form tests dwell on whether or not individual groups or investors have monopolistic access to relevant price formation information. However, since the hypothesis is null then a person would not expect it to be literally true and is as such viewed as a benchmark against which market efficiency deviations are able to be measured. On the other hand the semi-strong test is less restrictive. The information of interest in this form includes publicly available information. Lastly, the weak form test is concerned with return sequences or historical prices. According to Fama et al (2004) the efficient market model’s weak form test subset is the most voluminous and the results are in support of efficient market model. Though there is significant evidence available in support of dependence in price changes or returns some of the evidence is in line with “fair game” model. On the other hand the rest of the evidence does not appear as sufficient to enable the declaration of the market as inefficient. For price returns or changes that cover a day or more than a day there is not enough evidence against “fair game” model’s derivative random walk. There is therefore consistent evidence in support of positive dependence in the day to day changes in price and returns available on common stocks. The dependence is available in the form that can be utilized as a basis of the marginally profitable rules of trade. In Fama’s data dependence is shown as a number of correlations that are mostly positive but are also close to zero. As a small tendency for the observed numbers of given runs of negative and positive price changes to be not more than numbers which would be expected as a result of a purely random process. More vitally, Fama et al (2004) deduces that there is dependence in Alexander’s filter tests and also on Blume and Fama’s theories as a common occurrence whereby small filters produce a lot of profits that are more than those of given buy and hold. It has been further noted that any systems which try to convert short term dependence to trading profits of given necessity, develop a number of transactions that the profits that they expect would be able to be taken up even by the little commissions for instance security handling fees which are paid by floor traders that work on major exchanges. Thus, through the utilization of strict market efficiency interpretation the positive dependence is not enough to warrant the rejection of efficient markets model. Evidence that contradict “fair game” that is a form of the efficient market model that pertains to price returns or changes that cover longer periods than a given single day is very difficult to find. Fama (1991) deduces that Moore and Cootner report small negative serial correlations that exist in weekly common stock profits. The same results are reported in four day results that are also analyzed by Fama (1991). But it is also not reflected in Fama’s run tests where there is a small indication of positive dependence although in the same breath there is not a lot of evidence of dependence. There is also not any indication that dependence on weekly returns is able to be utilized as a basis of the formulation of trading rules which are profitable. There exists other evidence that show dependence in returns which provides interesting insights into methods used in price formation available for the stock market but it is however not relevant in testing efficient markets model. For instance Fama (1970) depicts that huge daily price changes are usually followed by huge changes although they are usually unpredictable. This implies that vital information cannot be entirely evaluated immediately but the initial day’s price adjustment of information is unbiased which is not adequate for the martingale model. More important is Niederhoffer-Osborne which finds a tendency toward a lot of reversals in the regular stock price changes that transcend transactions. This is explained as a logical result of a mechanism whereby directives to sell and buy in a given market are matched against the available orders on specialist books. Since there is a tendency of excessive reversals then there seems not to be a way in which profitable trading rule can be used. As it is claimed by researchers the results are in strong refutation of random walks theory when applied to changes in price as a result of transactions however they are not inclusive of economical refutation of the “fair game” efficient market model. The efficient markets hypothesis is also supported by the semi-strong form test. The form depicts that security prices fully reflects available market information. Fama et al (2004) deduce that information in stock splits that pertain to the firm’s future dividend payments is fully reflected in split share prices at the instance of the split. Fama et al (2004) also notes that Scholes, Ball and Brown came to a similar deduction with respect to information that is available in; common stock big block secondary issues, new issues and annual earning announcements that are given by firms. On the other hand the strong form, in which prices is thought to fully reflect all of the available information is usually thought of as a benchmark against which market efficiency deviations are marked against (in the strictest manner). According to Fama et al (2004) there has also been two observed deviations; by Scholes, Niederhoffer and Osborne. Niederhoffer and Osborne highlight that specialists who exist on major security exchanges bear monopolistic access to information which are on unexecuted limit orders that are utilized in the generation of trading profits. The aforementioned raises the question of whether or not the “market making” function of a given specialist could not be properly carried out by a given mechanism which did not imply monopolistic access to information. Scholes determines that corporate insiders usually have monopolistic access to their firm’s information. The only two groups that have documented to having monopolistic access to information are; specialists and corporate insiders. There is lack of evidence that other groups who exist in the investment community have access to monopolistic information. The efficient markets model therefore seems as a good first estimate to reality. A great number of financial statisticians and economists believe that the stock prices are partially predictable. A new type of economists emphasized behavioural and psychological elements of the determination of stock prices and came to be of the belief that future stock prices were predictable on the basis of stock price patterns of the past in conjunction with “fundamental” valuation metrics. In-addition a great number of economists made extensive controversial claims that the predictable patterns enabled investors to be able to earn a large quantity of risk adjusted rates of return. Malkiel (2003) suggests that even if errors are made during stock valuation the stock market is always efficient which was clearly depicted in 1999 during the internet bubble. Markets are efficient even in the event that stock prices exhibit a larger volatility than is apparently explained by fundamentals for instance dividends and earnings. Markets are also thought to be efficient because they reflect new information accurately and rapidly. Malkiel (2003) argues that market pricing is not largely perfect as was depicted in the latest internet bubble. In a nutshell, the evidence that supports efficient markets model is large and contradictory evidence is lacking. Alternative perspectives on the pricing of securities Malkiel (2003) suggest that there are psychological factors which may also influence on security prices that indicate that although a particular stock market may serve as a voting mechanism in a short period of time, it is thought of as weighing method over a long period of time. It is noted that true value always wins out at the end. The theoretical role and motivation of analysts in creating market efficiency According to Logue (2006) analysts are motivated into creating and enhancing market efficiency so as to answer the following theoretical questions; are transactions able to be carried out in the market at a relatively low cost? Are there available opportunities that allow for systematic profit which is as a result of serial correlation that is available in price series? Are there available market imperfections that prevent prices from immediately and fully reflecting novel information? The answers to the aforementioned questions allow for some uniformity in the stock market. It has been noted that analyst behaviour is the major determinant in the results obtained from theoretical but not observable in the transaction and equilibrium prices. Due to the aforementioned reason then it is imperative for analysts to create and enhance market efficiency. “Herd”’ and `the most emotional person’ references Psychologists and economists in behavioural finance field find that short run momentum is consistent with a number of psychological feedback mechanisms. It has been noted that when individuals see stocks to be rising then they are drawn into the market in a “bandwagon effect.” For instance, Malkiel (2003) describes an increase in U.S stock market in the course of the late 1990s which was as a consequence of psychological contagion that led to irrational exuberance. Another cause of short run momentum is that investors tend to under react to novel information. In the event that vital news impacted only over a short period of time then stock prices will depict positive serial correlation. As behavioural finance was more prominent as a part of financial study, momentum as disparate to randomness seemed reasonable to a great number of investors. It should however be noted that the statistical dependencies that gave rise to momentum was extremely minute and was not likely to allow investors to enjoy excess returns. It is therefore noted that anyone who pays the costs of transaction is not likely to fashion a trade strategy that is based on the types of momentum found in various studies would beat buy and hold strategy. Malkiel (2003) argues that momentum investors do not obtain excess returns. This is as a consequence of the large transaction costs associated with the attempt of the exploitation of whatever momentum that existed. Logue (2006) also determine that transaction costs that are involved in the undertaking of “relative strength” strategies are far from profitable as a result of the trading costs that are involved during the transaction. Fama (1991) finds that under-reaction to available information is just about as prevalent to over-reaction. Bibliography Fama, E. F (1970).Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance. Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, pp. 383-417 Fama, E.F (1991). Efficient Capital Markets: II. The Journal of Finance. Vol. 46, No. 5, pp. 1575-1617 Fama, E.F, French & Kenneth, R (2004). The Capital Asset Pricing Model: Theory and Evidence. The Journal of Economic Perspectives. Vol. 18 No. 3 Summer 2004, pp. 25-46 (22), published by American Economic Association. Malkiel, B.G (2003).The Efficient Market Hypothesis and its Critics. CEPS Working Paper No.91. Logue, D.E (2006). Market-Making and the Assessment of Market Efficiency. The Journal of Finance.Vol. 30, No. 1 (March), pp. 115-123 Read More