BUSFIN4221 – Investments (Module 4 – Market Efficiency)

Module 4: Market Efficiency

(BUSFIN 4221 – Investments)

Instructor:	Andrei S. Gonçalves
E-mail:	Andrei_Goncalves@kenan-flagler.unc.edu
Website:	andreigoncalves.com/BUSFIN4221

Welcome to Module 4!

Download the class slides here and the “to print” version here.

While the previous modules explore how to construct a portfolio and the implications of such approach to expected returns, they are silent regarding prices of financial securities. The Fundamental Valuation Equation suggests that prices are connected to discount rates, but also to cash flows. This Module helps us to understand the precise link between cash flows, discount rates, and prices and the implications of such link to the relation between discount rates and expected returns.

The broad idea of the Efficient Market Hypothesis (EMH) is outlined in the following diagram:

The idea is that as new relevant information arrives in financial markets, it is correctly incorporated into prices immediately (the gap between $t$ and $T$ is small). Otherwise, investors would be missing on opportunities to generate “abnormal” profits in financial markets. To make sense of this statement, we need to understand what it means for prices to “correctly incorporate information” and what is the definition of “relevant information”.

1) What does it mean for prices to “correctly incorporate information”?

Prices correctly incorporate information as long as investors estimate future cash flows making use of all information they have. In mathematical terms, estimated cash flows are given by the “statistical expectation” of future cash flows: $\mathbb{E}\left[CF_{t+h}\right]$ . This is because $\mathbb{E}\left[CF_{t+h}\right]$ is (mathematically) the best forecast for $CF_{t+h}$ (nothing can improve upon this).

We will see that if $\widehat{CF}_{t+h}=\mathbb{E}\left[CF_{t+h}\right]$ holds, then $\mathbb{E}\left[r\right]=dr$ follows automatically (under some technical assumptions). In words, if the EMH holds, then investors can (statistically) expect to receive precisely their discount rate (or required rate of return). That is a remarkable statement. It says that, under the EMH, the effective reward an investor receives for holding any asset is precisely the reward he/she requires in order to hold such asset.

So…”correctly incorporate information” simply means that current prices induce $\mathbb{E}\left[r\right]=dr$ for all financial assets.

2) Defining “relevant information”

The EMH comes in three alternative forms:

a) weak-form EMH: relevant information = trading data

b) Semistrong-form EMH: relevant information = all publicly available information

c) Strong-form EMH: relevant information = all information (private or public)

3) Empirical Evidence

After understanding 1) and 2), we will turn to the evidence regarding the EMH. Understanding whether the EMH holds is extremely important because it fundamentally changes how you should act in financial markets. If the EMH holds, then any investment pays its required rate of return and indexing might be the right way of investing. However, if the EMH does not hold, then you can decide whether to invest in a given asset using a two-step approach. First, you use your estimated cash flows and current prices to figure out the expected return the asset is currently paying. Second, you compare such expected return to your required rate of return (or discount rate) for investing in such asset. If the asset pays an expected return higher than you require, then you should buy it.

It is fair to say that, while there is substantial evidence that prices are not always efficient, the EMH is a good first approximation for how prices behave in financial markets. So, it is possible to find good opportunities in the market, but the EMH works reasonably well such that you should question yourself whenever you think you see such opportunity (you will find out that you are often wrong).

Finally, we will take a look at some of the ideas associated with Behavioral Finance, which is a field that has challenged the EMH over the last few decades. The idea is that if general investors make systematic mistakes and there are important limitations on the ability of smart investors to correct such mistakes, then prices will not be efficient.