Economic theory of price as the basis of the Efficient Market Hypothesis

1. Economic theory of price as the basis of the Efficient Market Hypothesis Robert W Vivian Professor of Finance and Insurance School of Economic and Business Sciences University of the Witwatersrand 21st SAFA Conference: Cape Town 18th January 2012

2. Economic theory of price and EMH • EMH is concerned with determining prices of equities • One of the central economic issues is the question of determining prices • EMH is simply a subset of this central economic issue • It stands to reason that the EMH should be contextualized within standard economic theory • Alternatively, if the EMH is something different then it in any event will make a contribution to central economic theory of price

3. Purpose of this paper • To cast the EMH within the context of standard economic theory of price

4. Part I: Theory of Price

5. Economic theory of price • Adam Smith’s famous enigmatic paragraph on ‘value in use and value in exchange’ • Value in exchange – price • Price is the factual quantum at which exchange takes place • It is a factual figure [ie not hypothetical nor a calculated figure] – The De Villiers’ point • Value in use leads to utility theory (George Stigler) • David Ricardo’s contribution – starts with value in use, exchange and ends the same way • David Ricardo’s “labourtheory of value” in exchange

6. Economic theory of price (cont) • Marx’s confusing labour theory of value • Contradiction in 1st volume, dies without resolving the contradiction. Engels undertaking to resolve the contradiction, was not resolved in 2nd or 3rd volumes • From Price theory to Microeconomics • Problem of price never really solved, became less central and the problem evolved into what is now what is micro economics – price often now the last chapter

7. Information theory of price • Information determines the price • Price = P[I(t)] • Forgets that the price is not determined - it is an agreed figure between buyer and seller • The problem of asymmetry of information • Akerlof’s ‘Market for Lemons’ • Serious implications where asymmetry exists • Rothschild and Stiglitz (1976) ‘Asymmetry and equilibrium in competitive markets’ • Markets without asymmetry of information – efficient markets

8. Part II: EMH – determining the price of equities

9. But first …The important issue of methodology“they that forget history will spend all their time re-discussing the resolved issues of history”

10. Forgotten research paradigm • Upto 1620 Aristotle’s deductive paradigm held sway • This was clearly a defective system as shown by Bacon (1620) • Aristotle’s system could not produce definitive answers • The superior modern scientific paradigm, a reaction to Aristotle’s deductive paradigm was the inductive paradigm • What is important is what we can observeand explain what we observe is important • The information theory of price and the efficient market hypothesis belongs to Aristotle’s deductive paradigm and should thus be approached with caution as is evident with over 40 years of research trying to prove or disprove it – that wasthe original problem with Aristotle’s deductive paradigm

11. Price in efficient markets • Prices are determined from information • The efficient market is a hypothetical market – an idealized market – it does not necessarily exist – it only existsin Aristotle’s deductive world • An efficient market is one in which all relevant information needed to determine the price is known to everybody trading in that market • An efficient market has no asymmetry of information

12. Implications of price in the hypothetical efficient market • PS,t = PS,t[IS,t(t)] = φS,t(t) …. (1) • PP,t= PP,t[IP,t(t)] = φP,t(t) …. (2) • The information is the total information, not only firm specific information • The most important piece of information, in determining any price is the prevailing price • Leads to a feedback loop which can be unstable • = φS,t(t) = φP,t(t) = φ(t) ; De Villiers’ point • Implications of the EMH • There cannot be any arbitrage profits • Very little disagreement on price • … etc

13. Real markets • Real markets may not behave as hypothetical markets are thought to behave because they are real • Do not confuse real markets for hypothetical efficient markets • Adds to the Aristoltean conundrum – 42 years of it • The behaviour of hypothetical markets should be determined hypothetically, not fromreal markets • Techniques may be found to escape Aristotle’s Conundrum, maze, labyrinth – eg work on mean reversion

14. Restating the EMH • Total information determines the price • Efficient markets are markets where all information needed to determine the price is known to all • No asymmetry of information • Insider Trading outlawed as Rules of the Club; insider traders ‘not our kind of person’ • No arbitrage profits to be earned • Little disagreement about price

15. What EMH does not mean • Price is the value of the firm • P=f(V) = V + λ or = kV • Price and value may differ significantly; mismatch between price and value • Profits cannot be made • If you are worried about profits and not price then look at the theory of perfect markets not the theory efficient markets • Bubbles are not possible • EMH has failed; Behavioural economics (finance) makes EMH redundant

16. Thank you!