(In)Efficient Markets

Jinfan Zhang

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 Reference: Chapter 11, BKM

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Overview
 Define what we mean by market efficiency

 Review the efficient markets debate

 Look at evidence for and against market efficiency

 Discuss rational and behavioral perspectives on

market anomalies

 Look at limits to arbitrage

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Winners of 2013 Nobel Prize for
Economics

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Bold claims in Media

The New Yorker:

Business Insider:

Forbes

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 Review of the Market Efficiency Debate

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Efficient Market Hypothesis
(EMH)
 EMH says stock prices already reflect all available
information

 A forecast about favorable future performance leads to

favorable current performance, as market participants
rush to trade on new information.

 Result: Prices change until expected returns are

exactly commensurate with risk.

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Definition of market
efficiency
 Market efficiency means that security prices are right
 i.e. they fully reflect all available information

 Equivalently, all prices equal their fundamental value

 use all available information to make the best possible cash-

flow forecast
 use a discount rate r that is appropriate for the risk

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Versions of the EMH
 Weak
 Market trading data
 Semi-strong
 All public information
 Strong
 All information, including insiders’ private information
 All versions assert that prices should reflect available
information

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Implications of the EMH(weak
form)
 Using prices and volume information to predict future
prices (Technical Analysis)

 Success depends on a sluggish response of stock

prices to fundamental supply-and-demand factors.

 Test of the weak form efficiency

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Technical Analysis
 Candle Plot
 Gold Crossing ( 金叉 )
 Short term moving average line
surpass the long term moving
average line upward.
 Dead Crossing ( 死叉 )
 Short term moving average line
surpass the long term moving
average line downward.

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Candle plot

 白三兵
 白三兵是牛市的逆转模式，形成三个连贯的长白蜡烛。在一段走低后，白三兵模式指示市场心态的改变和从熊市到牛市的逆转趋势。牛市的确认勿庸置疑，有
时逆转会形成一个价格支撑位。
 三个黑乌鸦
 熊市逆转模式，由三个连续的黑烛身组成。每天开盘时高于昨天的最低价，但收盘时低于昨天的最低价。

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Implications of the EMH (semi-
strong form)
 Fundamental Analysis - using economic and
accounting information to predict stock prices
 Try to find firms that are better than everyone else’s estimate.

 Try to find poorly run firms that are not as bad as the market
thinks.

 Test of the semi strong form efficiency

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Implications on Asset
Management
 Active Management
 An expensive strategy

 Passive Management:
 Accept EMH, don’t attempt to outsmart the market
 Index Funds and ETFs with very low costs

 The role of portfolio management in an efficient market

 Diversification
 Appropriate risk level

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Implications of market
efficiency
 Prices react to new information quickly and to the right
extent
 There is no free lunch:
 the only way to get higher returns is by taking on more risk
 there is no information out there that can be used to construct
strategies that earn returns higher than required for their risk
 A logic problem

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Theoretical argument for market
efficiency
 Milton Friedman (1953)
 If a security becomes mispriced, smart investors should
quickly take advantage of it, and the mispricing should
disappear quickly
 this process is often called “arbitrage”

 Anyone who claims markets are inefficient, must explain why

the arbitrage process breaks down
 major challenge for behavioral finance

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Why do we care?
 In an efficient market, resources have been allocated
efficiently by markets.

 There is no role for intervention

 In an inefficient market, capital is not properly

allocated across firms.

 Potentially, there is a role for regulation

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What does the evidence
suggest?

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How can we tell if markets are
inefficient?
 Can look for stocks whose prices seem wrong
 but hard to be sure the price is wrong
 when we say ‘prices are wrong’, we are implicitly stating
what ‘correct’ is

 Can look to see if new information is quickly and fully

incorporated into prices

 Can look for investment strategies that seem to earn

higher average returns than they deserve for their risk
 but hard to judge their risk, so it is hard to be sure they really
are earning more than they deserve

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Evidence for market
efficiency
 Professional money managers do not beat the market
on average

 What does this mean?

 There are no market inefficiencies to exploit?

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Evidence for market
efficiency
 New information appears to be quickly incorporated
into prices

 e.g. suppose “news” is the announcement of a takeover

 look at the target firm’s stock price reaction to the news

 average over many companies to see the typical pattern

 This is called an “event study”

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Event Studies
 Empirical financial research enables us to assess the
impact of a particular event on a firm’s stock price.

 The abnormal return due to the event is the difference

between the stock’s actual return and an estimate of
the stock’s return in the absence of the event.

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Event Studies

 Expected Return
rt = a + brMt + et

 Abnormal Return = (Actual - Expected)

et = rt - (a + b*rMt)

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Example: Cumulative Abnormal Returns
Before Takeover Attempts: Target
Companies

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Slow incorporation of news into
stock prices
 Earnings news does not appear to be quickly and fully
incorporated into prices

 On unexpectedly good news, a firm’s stock price

jumps up, but continues to drift up in the weeks
thereafter

 On unexpectedly bad news, a firm’s stock drops in

value, but continues to drift down in the weeks
thereafter

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Can the market calculate
addition and subtraction?
 Huancheng Du, Xiaoran Ni, Jinfan Zhang, The “Ex-dividend Day” Anomaly
under a Behavioral Dividend Clientele View: Evidence from China

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Can the market calculate
addition and subtraction?
 No

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Can the market calculate
addition and subtraction?
 No.
 Why? Naïve investors think divided as free lunch

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Can we come up with a
strategy that makes
money?

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Investment strategies that seem
to beat the market
 These are strategies that seem to earn higher average
returns than they should, for their risk

 e.g. if you regress excess strategy returns on excess

market returns, you get a positive alpha intercept:

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Average Annual Return for 10
Size-Based Portfolios, 1926 – 2011

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Example: Value vs. Growth
 Form portfolios based on prices to fundamentals
 use price to earnings (P/E) ratio
 could also look at price to book (P/B) and price to cash-flow
(P/CF) ratios
 Over many decades, average return of value stocks is
much higher than that of growth stocks
 but doesn’t appear to be riskier
 Value stocks (with low ratios) appear to earn higher
returns than they “deserve,” for their risk
 Growth stocks (with high ratios) appear to earn lower
returns than they “deserve,” for their risk

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Average Return as a Function of
Book-To-Market Ratio, 1926–2011

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Reactions to the evidence
 Behavioral finance people say:
 these strategies earn more average return than they should,
for their risk
 they must therefore be exploiting mispricing

 Rational finance people say:

 the strategies are risky, but the standard measures of risk fail
to capture this
 look for new ways to measure risk under which the strategies
do look risky

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 We can directly check whether stock price is
wrong
 Of course, the challenge is we are not sure what
is the correct price

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Evidence against market
efficiency
Cases where prices seem to move even though there is no new
information
 e.g. the 20% drop in the stock market in one day in October 1987
 The Treasury “flash” rally, occurred on Oct. 15, 2014 and only lasted for
about an hour. But the ferocity of the ascent — and the simultaneous
eye-popping plunge in the yield — prompted widespread concern about
the functioning of the market for Treasury securities.
 There are investment strategies that seem to have earned higher
average returns than is consistent with their risk (“beat the market”)
 these are so called “anomalies”
 Shiller (1981) provided evidence that the stock market prices are too
volatile to be explained by changes in fundamentals.

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Specific Examples--The Oct. 15, 2014
“flash rally” in US Treasury bond
market

The report asserts that the banks and principal trading firms
took steps to protect themselves from a rise in Treasury prices
— and those steps seemed to drive the prices even higher. The
banks widened the gap at which they would buy and sell
Treasuries, a standard practice in volatile moments in the
markets. At one point, they stopped offering to sell Treasuries.
The principal trading firms, for their part, reduced the average
size of their trades. “Both actions served as risk management
strategies by reducing the number and size of orders that could
be executed,” the report said.

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Specific Examples
 In March 2000, 3-Com sold 5% of its subsidiary Palm
in an initial public offering (IPO)
 after the IPO, 1 share of the 3-Com would effectively include
1.5 shares of Palm
 after the first day of trading, Palm was at $95
 in an efficient market, 3-Com should have been at $142, at
least!
 but it was at $82!
 market value of the 95% of Palm owned by 3-Com was almost
$25 billion greater than the market value of 3-Com.
 as if all of 3-Com’s other assets were worth a negative $25
billion

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Arbitrage
 One need to borrow the stock in order to short it.
 Mutual funds, trusts, and asset managers usually lend shares
and demand fees.

 It might be hard or impossible to borrow.

 It is costly to borrow shares. If the stock price is $10,

and lending fee is 10%, then one need to return one
share plus $1 if he borrows the stock for a year.

 Cost of shorting was 35% in July 2000 for Palm.

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Superstition Everywhere

 Chang and Du (2022)

1 million USD

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Stock primary market
 IPO and PEP

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FX market

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Commodity futures market

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Limits to arbitrage
 If stocks are mispriced, why doesn’t the arbitrage
process eliminate the inefficiency?
 The risk that mispricing will get worse in the short run
 Margin Call
 Fund managers are evaluated frequently
 The danger is that if the mispricing worsens, even temporarily, investors
will withdraw funds
 Knowing this, the fund managers don’t take too aggressive a position
against the mispricing, allowing it to survive

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Example: Twin shares (Royal
Dutch/Shell)
 Twin shares are shares that are claims to the same
cash-flow stream
 Royal Dutch shares
 Trade in the Netherlands and the U.S.
 Are a claim to 60% of the combined firm’s cash flow
 Shell shares
 trade in the U.K. and the U.S.
 are a claim to 40% of the combined firm’s cash flow

 In an efficient market, must have:

 but

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 prices can stay wrong, or become even more wrong

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Summary
 Debate over market efficiency continues …
 Both sides agree that there are many examples of
“anomalies”
 Disagree on what those “anomalies” mean for market
efficiency
 Even if prices are “wrong”, that doesn’t mean it’s easy
to beat the market!
 Next time: do hedge funds, mutual funds, etc. beat the
market?

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