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MARKET
EFFICIE
NCY
DR. MADHURI MALHOTRA
PHD IIT MADRAS
What is an efficient market ?
An efficient market is one in which the market price of a security is an
unbiased estimate of its intrinsic value.
Market efficiency does not imply that the market price equals intrinsic
value at every point in time.
The price can deviate from the intrinsic value but the deviations are random
and uncorrelated with any observable variable. If the deviations of market
price from intrinsic value are random, it is not possible to consistently
identify over or under-valued securities.
Market efficiency
is defined in relation to information that is reflected in
security prices.
Forms of Capital Market Efficiency
The finance theory refers to three forms of capital market efficiency:
 Weak form of efficiency

 Semi-strong form of efficiency
 Strong form of efficiency.
Weak form efficiency
Weak form of market efficiency The security prices reflect all past information about the
price movements in the weak form of efficiency.
It is, therefore, not possible for an investor to predict future security prices by analyzing
historical prices, and achieve a performance (return), better than the stock market index such
as the Bombay Stock Exchange Share Price Index or the Economic Times Share Price Index.
It is so because the capital market has no memory, and the stock market index has already
incorporated past information about the security prices in the current market price
Weak form efficiency …
How does one know that the capital market is efficient in its weak form?
To answer this question, we can find out the correlation between the ‘security prices over
time.’
In an efficient capital market, there should not exist a significant correlation between
the security prices over time.
Most empirical tests have shown that there exists serial independence between the
security prices over time.
In other words, share prices behave randomly.
Hence the weak form of efficiency is referred to as the random walk hypothesis.
An alternative method of testing the weakly efficient market hypothesis is to formulate
the trading strategies, using the security prices and compare their performance with the
stock market performance.
Weak form efficiency …
The capital market will be inefficient if the investor’s

trading strategy could beat the market.
Researchers have studied a large number of trading
rules, and have concluded that it is not possible for
investors to outperform the market.
Market efficiency theory focuses on “ How the
market securities behave in relation to its
fundamentals”.
Efficient Market Theory
“Security prices accurately reflect available information, and respond rapidly to new information
as soon as it becomes available”
………………………………………………….Richard Brealey & Stewart Myers, Principles of Corporate
Finance, 1996
II Semi Strong Form Efficiency
Semi-strong efficiency: Semi-strong form efficiency Prices reflect

not only all information found in the record of past prices and
volumes but also all other publicly available information.
This form of EMH implies that all public information is calculated
into a stock's current share price.
Neither technical nor fundamental analysis can be used to achieve
superior gains.
Monday, December 11, 2023

How to estimate whether market is semi-strong
form efficient?
Event Study

Studies of the semi-strong form of the efficient markets hypothesis can be categorized as
◦ Tests of the speed of adjustment of prices to new information. The principal research
tool in this area is the event study.
◦ An event study averages the cumulative performance of stocks over time, from a
specified number of time periods before an event to a specified number of periods after.
Performance for each stock is measured after adjusting for market-wide movements in
security prices.
The first event study was undertaken by Fama, Fisher, Jensen and Roll (1969), though the
first to be published was by Ball and Brown (1968).

Overview of event Studies
1. Event studies examine the effect of some
event or set of events on the value of assets.
2.Unexpectedly large increase or decrease

What is an EVENT ?
Some change, development, announcement that may produce a relatively large change in the
price of the asset over some period.
1. Stock splits
2. Earning announcements
3. Merger or takeover announcements
4. Regulatory change
5. any other announcement or event

Procedure

Define an event window – a period over which the event occurs
Define an estimation window – a period over which parameters are
estimated
(T0...T1] is estimation window

(T1...T2] is event window
(T2...T3] is post-event window

How to estimate return due to event
Calculate Returns of the firms during the event window using the standard formula
Today’s price – yesterday’s price

_________________________________
Yesterday’s price

Estimate returns during the event window
Estimate market index returns
Return during the event window minus market index returns is
abnormal returns .

Market adjusted Returns Method to estimate
Abnormal Returns
ARit = Rit – Rmt
ARit is the abnormal returns

Rit is the firm’s returns
Rmt is the market Index Returns
This method allows for general market movements, but assumes each
firm has same average return and risk characteristics as market as a
whole

Aggregation of Abnormal Returns
Aggregate returns over time and across Firms
Over time : aggregate across different time periods to see if effect develops over time
Across firms : Aggregate across firms in the sample.

Aggregate over time
CARi is Cumulative Abnormal Return for firm I Under the null hypothesis of
no abnormal return, the abnormal return is zero.
The term CAR(-5, 0) means the CAR calculated from five days before the
announcement to the day of announcement.

Empirical Evidence on the Strong-form Efficient Market
The strong-form efficient market hypothesis holds that all available information, public
or private, is reflected in the stock prices. Obviously, this represents an extreme
hypothesis and we would be surprised if it were true.
To test the strong-form efficient market hypothesis, researchers analysed the returns
earned by certain groups (like corporate insiders, specialists on stock exchanges, and
mutual fund managers) who have access to information which is not publicly available
They must possess greater resources and abilities to intensively analyse information
which is in the public domain.
Strong form efficiency
Corporate insiders (who may benefit from access to inside information) and stock exchange
specialists (who have monopolistic access to buy and sell order position) earn superior rates of
return, after adjustment for risk.
Mutual fund managers do not, on an average, earn a superior rate of return.
There is no scientific evidence to suggest that professionally managed portfolios as a group
perform better than randomly selected portfolios.
ASSIGNMENT
TAKE 2 STOCKS OF THE SAME SECTOR
DOWNLOAD THE SHARE CLOSING PRICE FORM BSE WEBSITE / ANY OTHER RELEVANT WEBSITE
CALCULATE STOCK RETURNS
PLOT THE RETURNS IN CHART – OBSERVE AND COMMENT ON THE TREND

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MARKET

The finance theory refers to three forms of capital market efficiency:

 Weak form of efficiency

The capital market will be inefficient if the investor’s

Semi-strong efficiency: Semi-strong form efficiency Prices reflect

Monday, December 11, 2023

Monday, December 11, 2023

Monday, December 11, 2023

Monday, December 11, 2023

Monday, December 11, 2023

Monday, December 11, 2023

(T0...T1] is estimation window

Monday, December 11, 2023

Today’s price – yesterday’s price

Monday, December 11, 2023

Monday, December 11, 2023

ARit is the abnormal returns

Monday, December 11, 2023

Monday, December 11, 2023

Monday, December 11, 2023

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