MARKET EFFICIENCY
Efficiency with respect to an information set implies . . . that it is impossible to make abnormal profits by trading on the basis of that information set.
1. Prices in mkt reflect info about securities =>won’t be easy to find NPV>0 for financing i.e. under/overpriced securities is unlikely.
2. Market is efficient w/ respect to some info set if security prices would be unaffected by revealing that info to all participants.
Weak Market reflects all info about past prices therefore can’t make abnormal profits based on past info. If it holds, Covariance (tomorrow’s abnormal return, today’s abnormal return) = 0, stock prices follow “random walk”. Test: transaction costs make technical trading not have a positive NPV.
Semi Strong Weak plus - all publicly available info (i.e. rapid reaction time = can’t make money on the news)
Test 1: active mgt funds in general perform worse than mkt. If info is already reflected in prices, extra costs of research & transaction of actively mgd fund vs tracker fund, incurred in vain
Test 2: Study cumulative abnormal returns over time. Results show that info gets incorporated immediately (immediately rise (or fall) of prices), and starts to get incorporated before (insider’s info)
Strong Semi Strong plus info NOT publicly available (inside info)
Test: (Test 2 for semi), shows that there is insider’s trading or info leakage, also regulation
Implications of mkt efficiency:
- Expected return on a stock is exactly the one to compensate investors for the risk that they absorb (calculated using CAPM). There are no financial projects with positive NPV.
- Different choices of accounting practices have no impact on stock prices if they have no impact on cash flows α = how much average stock price changed when mkt index Unchanged β = how much EXTRA the stock price moved for each 1 % change in mkt index