Chapter 11
Efficient Capital Markets: Evidence
1. Roll’s critique (1977) is based on the assumption that capital markets are in equilibrium. What happens when the market is not in equilibrium? Suppose new information is revealed such that the market must adjust toward a new equilibrium which incorporates the news. Or suppose that a new security is introduced into the marketplace, as was the case of new issues studied in the Ibbotson (1975) paper. Given such a situation, the abnormal performance of an asset can be measured by the arbitrage profits available as its price is adjusted to a new market equilibrium. Before the disequilibrium situation as well as afterward, Roll’s critique applies and we cannot expect to observe any abnormal performance relative to an efficient index. However, the adjustment process itself can be used to detect abnormal performance relative to the market index prior to equilibrium. In this way, Ibbotson’s results can be interpreted either as 1) selection of an inefficient index, or 2) detection of abnormal performance during disequilibrium. 2. (a) The securities market can be efficient even though the market for information is not. All that is required for efficient securities markets is that prices fully reflect all available information. Should an individual—for example, a corporate insider—have monopoly access to valuable information, then the market cannot reflect the information because it is not publicly available. This is not a deficiency in the securities market, but rather a deficiency in the market for information. The quote taken from the special committee of the Securities and Exchange Commission is correct when it says that the efficient markets theory is silent as to the optimum amount of information required—that issue can be decided by better understanding of the supply of and demand for information. (b) Information is