By Senlei Wang Zhi C hen Xiang Guo Qianhao Wei Qizhen Shao

1. The Theory of Stock Market Efficiency By Senlei WangZhiChenXiang GuoQianhao WeiQizhen Shao

2. Introduction • In the theory of stock market efficiency, public information that has not been fully reflected in stock prices. • In an efficient market, the stock price adjustment to the information should be rapid, and the new price should make the stock a “fair game”-one which promises new investors a normal rate of return.

3. Introduction • The impact of the simple idea of market efficiency has been extensive and enduring. At the same time it was expanding our knowledge of how the stock market processes information, the early work on market efficiency helped to establish a receptive climate for three other major developments in financial theory: • 1. The Miller-Modigliani theories of corporate financial policy • 2. The Sharpe-Linter Capital Asset Pricing Model (CAPM) • 3.The Black-Scholes option pricing model

4. Introduction • Our current understanding of how information is incorporated into stock prices has also influenced corporate disclosure policy. • However, the theory of efficient markets has obvious limitations. In author’s opinion, that information is costlessly incorporated into prices. • In reality, investors interpret events differently; they face considerable uncertainty about why others are trading; the smaller firms face high costs in acquiring and processing information especially.

5. Introduction • The author’s view is that the theory of efficient markets was an audacious and welcome change from the comparative ignorance about stock market behavior that preceded it; although it has some defects, it has profoundly influenced both the theory and practice of finance.

6. The idea that Markets are “efficient” • In 1968, academics in finance and economics conducted little or no research on stock price. • Random walk hypothesis----price on any given day appeared likely to go up or down with roughly equal probability . The result lacks an economic explanation. • In an efficient financial market, price fully and instantaneously reflect all available relevant information. • Security prices should adjust to information as soon as it becomes publicly available.

7. Accomplishments of the Theory Of Stock Market Efficiency • In 1969, a study of the stock market reaction to stock splits by EugenaFama, Lawrence Fisher, Michael Jensen, and Rchard Roll explained how stock prices respond to new information.

8. Accomplishments of the Theory Of Stock Market Efficiency Figure 1. Stock price changes in relation to stock splits.

9. Influencing the Climate for Other Financial Economic Theories • The market efficiency theory and evidence on market efficiency demonstrated to economists that share price behavior could be viewed as a rational economic phenomenon. • Capital asset pricing model (CAPM) provided researchers with a method of estimating investors’ “expected” returns- the returns passive investor would otherwise have earned in the absence of the information being tested

10. Summing Up • Research on market efficiency spread rapidly across the globe. • Research had an enduring impact on our view of stock markets, financial markets, and markets of all kinds. • Academic attitudes toward stock markets had shifted from suspicion to almost reverence.

11. Limitations in the Theory of Efficient Markets • The theory's failure to explain certain aspects of share price behavior (anomalies) • Defects in efficiency as a model of markets • Problems in testing the efficiency model

12. Empirical Anomalies: Problems in Fitting the Theory to the Data • Price Overreactions • Excess Volatility • Price Underreactionto Earnings • The Failure of CAPM to Explain Returns • The Explanatory Power of Non-CAPM Factors • Seasonal Patterns

13. Defect in “Efficiency” as a Model of Stock Market • Failure to include the cost of acquiring and processing the information. • The costs of acquiring and processing information do not receive enough attention in the theory and empirical research on stock market efficiency. • To date, researchers are leaningto ignore information costs and are depending on publicly-disclosed information (arbitrarily define as zero cost) in testing market efficiency.

14. Defect in “Efficiency” as a Model of Stock Market • Heterogeneous Information and Beliefs. • The efficient market theory assumes that investors are homogenous and rational to process information. • In reality, publicly available information do not have the same implications for all investors. • Individual investors will have huge difference in beliefs and intuition, and a single piece of information may be analyzed very differently by different investors.

15. Defect in “Efficiency” as a Model of Stock Market • A Brief Digression on the Role of Security Analysts • The efficient markets theory ignore the economic role of security analysts and public commentary. This phenomenon even let many academics to view these two factors as unnecessarily. • Both factors can reduce investors uncertainty and cost about the information and trading motives of other investors.

16. Defect in “Efficiency” as a Model of Stock Market • Failure to Consider Transactions Costs • The efficient markets theory regards the markets as costless in operating. • However, if stock markets are large-scale, the high-turnover institutions still can not eliminate transaction cost. • Neglecting the Market Microstructure Effect • This effect is that the market mechanism has influence on the actually transactions price.

17. Problems in Testing “Efficiency” as a Model of Stock Market • The investors’ ability to exploit public information for gain can be tested only by comparing the returns earned. • As the CAPM model, E(R)=Rf +B(Rm-Rf). • Changes in Riskless Rates and Risk Premiums • The CAPM model assumes the risk-free risks and market risk premiums are constant, thus it has limited ability to judge the stock price volatility, market index variance and other important issues. • Trends in Real Rates and Market Risk Premiums • The CAPM model does not indicate the correlation in changes in the risk-free rate or the market risk premium.

18. Problems in Testing “Efficiency” as a Model of Stock Market • Changes in Betas • The current theory provides no evidence to show the changes in betas and to measure how betas can be viewed as efficient in the market. • Seasonal Patterns in Beta • There is no reason in principle why securities’ relative risk, can not say the day-of-the-week.

19. Is “Behavioral” Finance The Answer? • The profit opportunities created by investors seem inconsistent with competitive market. • Behavioral finance has anomalies of its own. • Research process was not objective and open enough to accept dissenting views.

20. Conclusion • On the one hand, the research provides insight into stock price behavior. • On the other hand, the theory of efficient markets is an imperfect and limited way of viewing stock markets. • People can not expect that security prices do restore equilibrium in response to new information. • Most of evidence on stock price behavior does not address the factual issue of efficiency.

21. Conclusion • The economic theory of competitive markets is not willing to wipe off the important role in stock market research, for several reasons. • First, stock markets must rank highly among markets on a preferred possibility of being competitive. • Second, the inevitability of binding limitations in both our models of efficiency and in the available data provides a credible alternative explanation for the range of anomalies that have been documented over the last decade. • Third, the author checks the transformation from the view of securities markets and know how well prices respond to information.