FINANCIAL ECONOMICSLECTURE 9

“Efficient” MarketsStephen Kinsella

LAST TIME.Capital Asset Pricing/Arbitrage Pricing Theory

LEARNING OUTCOMESRecap CAPM/APT

Define/Describe Efficient Markets HypothesisIntroduce Adaptive Markets Hypothesis

IN THE NEWSDavy: Celtic Tiger Wealth Largely Squandered apart from roads

EU Manufacturing Collapsing

Review

Lowest Risk�Expected Return Profile

0.0 0.1 0.2 0.3 0.4Σp0.0

0.2

0.4

0.6

0.8

E�Rp� Efficiency Frontier

Rm

ΣmΣm

Σm

M

0.0 0.2 0.4 0.6 0.8Σp0.0

0.5

1.0

1.5

E�Rp�Capital Market Line

EFFICIENT MARKETS HYPOTHESIS

EFFICIENT MARKETS HYPOTHESIS

Market efficiency: Current prices reflect all the publicly available information about a security.

or : prices follow a random walk

Rit+1=E(Rit+1/It)+Uit+1.

Rit return on an asset i at time t+1.

The (Rit+1/It) captures the return divided by the amount of information available in the market, and the error term, Uit+1is what we're really interested in.

Random Walk(s)

MATHEMATICA

This error term is the prediction error. Randomness implies the prediction error should have certain characteristics, which we can test for.

1. Uit+1 should have an expected value of zero, so all errors cancel each other out in the long run.

2. Uit+1 should be independent of the return on the asset: the correlation coefficient should be close to zero.

3. There should be no way to predict the size of the error term from moment to moment.

VERSIONS OF EMH

Weak version: it is impossible to predict future movements in asset prices on the basis of past movements.

Semi strong version: asset prices are at least as good as any estimate that can be made on the basis of publicly available information.

Strong version: asset prices represent the best possible estimate taking account of all information, both public and private.

IMPLICATIONS

When information arises, the news spreads very quickly and is incorporated into the prices of securities without delay.

Implication 1: Technical analysis is useless/misguided

Implication 2: Less regulated markets are better

Implication 3: Equity Premium Puzzle (Rogoff reading): average returns to equity are far higher than can be accounted for by any sensible model incorporating both reasonable risk attitudes and the efficient markets hypothesis

CRITICISM

Original studies: measures of short-run serial correlations between successive stock-price changes: no memory. Newer studies: anomalies!

Grossman/Stiglitz: 1980. EMH couldn’t ever work. If there aren't some inefficiencies, there isn't any incentive for market players to gather information (which makes markets efficient).

KUHNIAN CHANGE

• A paradigm is a coherent way of seeing the world: Classical Newtonian Physics.

• All theories have a life cycle.

• Big bang

• Propagate/stretch to explain new phenomena

• Crack & get replaced. EMH -> AMH (or something else)

T. Kuhn, The Structure of Scientific Revolutions

ANOMALIES

• January Effect

•Overconfidence/Overreaction

• Herding/Mental Accounting

ADAPTIVE MARKETS HYPOTHESIS

AMH (LO)

• Inefficiencies can exist, but market participants search them out and eventually arbitrage them away until the profits from using these patterns get too small to be worth the effort.

•Markets are efficient in a long-term, evolutionary sense.

•Market actors have ‘bounded rationality’

ASSUMPTIONS OF AMH (LO, 2004)

1. Individuals Act In Self-Interest

2. Individuals Make Mistakes

3. Individuals Learn and Adapt

4. Competition Drives Adaptation and Innovation

5. Natural Selection Shapes Market Ecology

6. Evolution Determines Market Dynamics

IMPLICATIONS OF AMH

• Risk/Reward Relation Not Stable

• Risk Premia Are Time-Varying

• Limited Arbitrage Exists From Time To Time

• Adaptation andInnovation Are Keys To Survival

• Survival is all that matters

WRITE DOWN 2 THINGS YOU REMEMBER!

MY SUMMARY

• EMH is dead.

• AMH is a hodgepodge of ideas, loads of interesting FYP/thesis topics here if people are interested.

LEARNING OUTCOMESRecap CAPM/APT

Define/Describe Efficient Markets HypothesisIntroduce Adaptive Markets Hypothesis

NEXT TIMEBond markets. Please read Pilbeam, Cht 6.

FINANCIAL ECONOMICSLECTURE 9

“Efficient” MarketsStephen Kinsella