Capital Market Efficiency free essay sample

There are three types of market efficiency: O  Ã‚  Ã‚  Ã‚  Ã‚   when prices are determined in a way that equates the marginal rates of return (adjusted for risk) for all producers and savers, market is said to be allocationally efficient; O  Ã‚  Ã‚  Ã‚  Ã‚   when the cost of transfering funds is â€Å"reasonable†, market is said to be operationally efficient; O  Ã‚  Ã‚  Ã‚  Ã‚   when prices fully reflect all available information, market is said to be informationally efficient. Bachelier (1900): In the opening paragraph of his dissertation paper, he recognise that: â€Å"past, present and even discounted future events are reflected in market price, but often show no apparent relation to price changes†. Samuelson (1965): In his article, â€Å"Proof that properly anticipated prices fluctuate randomly†, he asserted that: â€Å"†¦competitive prices must display price changes†¦that perform a random walk with no predictable bias. † Therefore, price changes must be unforcastable if they are properly anticipated. Jensen (1978): says that prices reflect information up to the point where the marginal benefits of acting on the information (the expected profits to be made) do not exceed the marginal costs of collecting it. We will write a custom essay sample on Capital Market Efficiency or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Malkiel (1992): offered the following definition: â€Å"A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set†¦if security price would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an informational set †¦implies that it is impossible to make economic profits by trading on the basis of (that informational set). † Lo and MacKinlay (1999): say: â€Å"†¦the Efficient Markets Hypothesis, by itself, is not a well-defined and empirically refutable hypothesis. To make it operational, one must specify additional structure, e. g. , investors’ preferences, information structure, business conditions, etc. But then a test of the Efficient Markets Hypothesis becomes a test of several auxiliary hypotheses as well, and a rejection of such a joint hypothesis tells us little about which aspect of the joint hypothesis is inconsistent with the data. † The â€Å"Bad Model† problem: Efficiency per se is not testable. It must be tested jointly with some model of equilibrium. When we find anomalus evidence on behavior of returns, the way it should be split between market inefficiency or a bad model of market equilibrium is ambiguous (Fama-1991) Tests of market efficiency: one must specify the information set used; * one must specify a model of normal returns (the classic assumpion is that normal returns are constant over time); * abnormal returns are computed as difference between the return on a security and its normal return, and forcast of the abnormal return are constructed using the chosen information set. If abnormal return is unforcastable, and in this sense â€Å"random†, then the hypothesis of market efficiency is not rejected. Tests of market efficiency – Weak-form tests The question is: How well do past returns predict future returns? The main assumption is that there should be no pattern in the time series of returns. Three theories of time series behaviour of prices can be found in the literature: * the fair-game model; * the martingale or submartingale model; * the random walk model. * Tests of market efficiency – Weak-form tests * The martingale model * Is also a fair game, where tomorrow’s price is expected to be the same as today (the expected return is zero).