Chapter 8: Stock Price Behaviour and Market Efficiency
8.1 Introduction to Market Efficiency
Efficient Markets Hypothesis (EMH) – the hypothesis stating that, as a practical matter, investors cannot
consistently ‘beat the market’
A theory that asserts: As a practical matter, the major financial markets reflect all relevant information at a given
Market efficiency research examines the relationship between stock prices and available information.
o The important research question:is it possible for investors to “beat the market?”
Prediction of the EMH theory: if a market is efficient, it is not possible to “beat the market” (except
8.2 What Does ‘Beat the Market’ Mean?
The excess return on an investment is the return in excess of that earned by other investments that have the
“Beating the market” means consistently earning a positive excess return
an investment has outperformed other investments of the same risk
8.3 Foundations of Market Efficiency
Three economic forces can lead to market efficiency:
1. investor rationality
2. independent deviations from rationality
Investors use their information in a rational manner.
Rational investors do not systematically overvalue or undervalue financial assets.
If every investor always makes perfectly rational investment decisions, it would be very difficult to earn an
There are independent deviations from rationality.
Suppose that many investors are irrational.
The net effect might be that these investors cancel each
So, irrationality is just noise that is diversified away.
What is important here is that irrational investors have
Suppose collective irrationality does not balance out.
Suppose there are some well-capitalized, intelligent, and
If rational traders dominate irrational traders, the market will still be efficient.
These conditions are powerful that any one of them can result in market efficiency
8.4 Forms of Market Efficiency
A Weak-form Efficient Market is one in which past prices and volume figures are of no use in beating the
o If so, then technical analysis is of little use.
A Semistrong-form Efficient Market is one in which publicly available information is of no use in beating the
o If so, then fundamental analysis is of little use.
A Strong-form Efficient Market is one in which information of any kind, public or private, is of no use in beating
o If so, then “inside information” is of little use.
8.5 Why would a Market be Efficient?
The driving force toward market efficiency is simply competition and the profit motive
Using the most advanced information processing tools available, investors and security analysts constantly
appraise stock values, buying those stocks that look even slightly undervalued and selling those that look even
This constant appraisal and subsequent trading activity act to ensure that prices never differ much from their
efficient market price. 8.6 Some Implications of Market Efficiency
Does Old Information Help Predict Future Stock Prices?
This is a surprisingly difficult question to answer clearly.
Researchers have used sophisticated techniques to test whether past stock price movements help predict future
stock price movements.
o Some researchers have been able to show that future returns are partly predictable by past returns. BUT:
there is not enough predictability to earn an excess return.
o Also, trading costs swamp attempts to build a profitable trading system built on past returns.
o Result: buy-and-hold strategies involving broad market indexes are extremely difficult to outperform.
Technical Analysis implication: No matter how often a particular stock price path has related to subsequent stock
price changes in the past, there is no assurance that this relationship will occur again in the future.
Random Walks and Stock Prices
If you were to ask people you know whether stock market prices are predictable, many of them would say yes.
To their surprise, and perhaps yours, it is very difficult to predict stock market prices.
In fact, considerable research has shown that stock prices change through time as if they are random.
That is, stock price increases are about as likely as stock price decreases.
Random Walk – no discernible pattern to the path that a stock price follows through time
How Does New Information Get Into Stock Prices?
In its semi-strong form, the EMH states simply that stock prices fully reflect publicly available information.
Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock.
But, the future prospects for the stock are influenced by unexpected news announcements.
Prices could adjust to unexpected news in three basic ways:
o Efficient Market Reaction: The price instantaneously adjusts to the new information.
o Delayed Reaction: The price partially adjusts to the new information.
o Overreaction and Correction: The price over-adjusts to the new information, but eventually falls to the
Researchers have examined the effects of many types of news announcements on stock prices.
Such researchers are interested in:
o The adjustment process itself
o The size of the stock price reaction to a news announcement.
Event Study – a research method designed to help study the effects of news on stock prices
o On Friday, May 25, 2007, executives of Advanced Medical Optics, Inc. (EYE), recalled a contact lens
solution called Complete MoisturePlus Multi Purpose Solution.
o Advanced Medical Optics took this voluntary action after the Centers for Disease Control and Prevention
(CDC) found a link between the solution and a rare cornea infection.
o The medical name for this cornea infection is acanthamoeba keratitis.
o The event study name for this cornea infection is AK.
o EYE Executives chose to recall their product even though no evidence was found that their manufacturing
process introduced the parasite that can lead to AK.
o Further, company officials believed that the occurrences of AK were most likely the result of end users
who failed to follow safe procedures when installing contact lenses.
o On Tuesday, May 29, 2007, EYE shares opened at $34.37, down $5.83 from the Friday closing price. When researchers look for effects of news on stock prices, they must make sure that overall market news is
accounted for in their analysis.
Abnormal Returns – the remaining return on a stock after overall market returns have been removed
To separate the overall market from the isolated news concerning Advanced Medical Optics, Inc., researchers
would calculate abnormal returns:
Abnormal return = Observed return – Expected return
The expected return is calculated using a market index (like the Nasdaq100 or the S&P 500 Index) or by using a
long-term average return on the stock.
Researchers then align the abnormal return on a stock to the days relative to the news announcement.
o Researchers usually assign the value of zero to the news announcement day.
o One day after the news announcement is assigned a value of +1.
o Two days after the news announcement is assigned a value of +2, and so on.
o Similarly, one day before the news announcement is assigned the value of -1.
According to the EMH, the abnormal return today should only relate to information released on that day.
To evaluate abnormal returns, researchers usually accumulate them over a 60 or 80-day period.
The next slide is a plot of cumulative abnormal returns for Advanced Medical Optics, Inc. beginning 40 days
before the announcement.
o The first cumulative abnormal return, or CAR, is just equal to the abnormal return on day -40.
o The CAR on day -39 is the sum of the first two abnormal returns.
o The CAR on day -38 is the sum of the first three, and so on.
o By examining CARs, researchers can see if there was over- or under-reaction to an announcement.
As you can see, Advanced Medical Optics, Inc.’s cumulative abnormal return hovered around zero before the
After the news was released, there was a large, sharp downward movement in the CAR.
The overall pattern of cumulative abnormal returns is essentially what the EMH would predict.
o There is a band of cumulative abnormal returns,
o A sharp break in cumulative abnormal returns, and
o Another band of cumulative abnormal returns.
8.7 Informed Traders and Insider Trading
Informed Trader - an investor who makes a buy or sells decision based on public information and analysis
If a market is strong-form efficient, no information of any kind, public or private, is useful in beating the market.
But, it is clear that significant inside information would enable you to earn substantial excess returns.
It is illegal to make profits on non-public information.
o It is argued that this ban is necessary if investors are to have trust in stock markets.
It is important to be able to distinguish between:
o Informed trading
o Legal insider trading
o Illegal insider trading
The information that an informed trader possesses might come from:
o Reading the Wall Street Journal
o Reading quarterly reports issued by a company
o Gathering financial information from the Internet
o Talking to other investors
Who is an Insider?
For the purposes of defining illegal insider trading, an insider is someone who has material non-public
Such information is both not known to the public and, if it were known, would impact the stock price.
A person can be charged with insider trading when he or she acts on such information in an attempt to make a
Legal Insider Trading
Some informed traders are also insider traders.
When you hear the terminsidertrading, you most likely think that such activity is illegal.
But, not all insider trading is illegal. Company insiders can make perfectly legal trades in the stock of their company.
They must comply with the reporting rules.
In addition, corporate insiders must declare that trades that they made were based on public information about
the company, rather than “inside” information.
Most public companies also have guidelines that must be followed. For example, it is common for companies to
allow insiders to trade only during certain windows during the year, often sometime after earnings have been
Illegal Insider Trading
When an illegal insider trade occurs, there is a tipperand a tippee.
The tipper is the person who has purposely divulged material non-public information.
The tippee is the person who has knowingly used such information in an attempt to profit.
It is difficult for the to prove that a trader is truly a tippee.
It is difficult to keep track of insider information flows and subsequent trades.
Suppose a p