NUST

FINANCIAL
INSTITUTIONS AND
MARKETS
assignment 2

BY

ALI RAZA ANJUM

EMBA 2K14

EFFICIENT MARKETS THE THEORY

A theory relating to the functioning of capital markets i.e. the Efficient
Market Hypothesis (EMH) was put forward by Eugene Fama in 1970.
According to Fama, the function of capital markets is the efficient
allocation of resources which requires that prices of market securities
accurately reflect all information to function as signals for
investments decisions for both producers and investors.
An ideal market in which prices always fully reflect all available
information in considered an efficient market. Fama went on to
present empirical tests for three forms of market efficiency in which
prices adjust to three different information levels;
1. Weak form efficiency are prices changes related to historical
prices?
2. Semi-strong form efficiency do prices change in response to
announcements and other publicly available information?
3. Strong-form efficiency the impact of availability of insider
information on securities pricing.
Assumptions used to form testable models of the theory are
presented below, along with supporting empirical evidence in the next
section.
Assumption 1: Fair Game model
Conditions of market equilibrium can be stated in terms of expected
return and the expected return expectations are formed on the basis
of available information. The implication is that it is impossible for
trading systems to gain higher than expected equilibrium market
return using information contained in the set used to set those
expectations.
Assumption 2: The submartingale model
The assumption that the price of a security follows a martingale i.e. it
must be equal to or higher than previous value at some point in time.
This implies that past information has no bearing on future value.
Assumption 3: Random walk model
The underlying assumption of efficient markets, that price of a
security fully reflects all available information, implies that any
subsequent price changes are independent events.
Assumption 4: Sufficient market conditions
For market efficiency to exist, there should be no transaction costs,
information should be freely available to all and there should be

agreement among investors as to implications of available

information. However, these conditions are not met in real-world
markets; and yet, this in itself is not sufficient to discount the
efficiency of markets as shown by empirical evidence.

EMPIRICAL EVIDENCE

WEAK FORM TESTS

One of the earliest observations of the weak-form market efficiency,

i.e. that speculative price changes are not based on historical trends
was first recorded in 1953 by Kendall who examined the weekly
changes in 19 indices of British industrial share prices as well as spot
prices for cotton in New York and wheat in Chicago and found these
exhibited random walk as the efficiency model predicted.

in series of prices which are observed at fairly

close intervals the random changes from one term to
the next are so large as to swamp any systematic
effect which may be present. The data behave almost
like wandering series. - Kendall
Filter tests performed by Alexander, using daily data on price indices
from 1897 1959 and filters from 1% to 50%, showed conclusively
that this filter strategy could not beat buy-and-hold strategies, which
is considered sufficient condition even if some of the data points
against presence of random walk in price changes. Fama-Blume
further concur, finding that the transactions costs involved in frequent
trades necessitated by filter strategy based on very short-term priceswings that were found to beat buy-and-hold strategies, would tend to
wipe out any excess gains.
SEMI-STRONG FORM TESTS

Most semi-strong form of efficiency tests are concerned with price

adjustments to particular kinds of public information generating
events (announcement of stock splits, dividends etc.).
Using the residual analysis method, it was shown by Fama, Fisher,
Jensen and Roll that pertaining to stock split announcements the
market does seem to behave efficiently by adjusting prices according

to forecasts of stock split implications for future dividends by the end

of the split month.
The same method was applied by Ball and Brown to annual earnings
announcements; classifying increases or decreases relative to the
market in annual earnings using residuals from time series regression
of a firms annual earnings on the average earnings of 261 major firms
for the period 1946-66. They too found anticipatory price adjustments
manifested by the announcement month 85 90% of the time.
STRONG-FORM TESTS

Strong form tests are concerned with proving that no individual has
expectations of higher than market average returns due to
monopolistic access to inside information as all information is
already reflected in market prices a situation that is far removed
from reality in practice.
Jensen developed tests using the returns from a nave strategy,
followed by an investor who assumes all information is reflected in
market prices, to establish the norm against which he measured
mutual fund performance to uncover whether any special
information allowed them to perform better. The answer proves to be
in the negative; even disregarding loading charges, or accounting for
brokerage commissions the performance of most mutual funds seems
to be below market line. Even those funds that perform better in one
sub-period are unable to sustain the performance in subsequent
periods.

these analysts operate in the securities

markets and have wide ranging contacts and
associations in both the business and financial
communities. Thus, the fact that they are apparently
unable to forecast returns accurately enough to
recover their research and transactions costs is a
striking piece of evidence in favor of the strong form
of the martingale hypothesis - Jensen

ANOMALIES
In this section we present examples of market behavior in practice
that would seem to contradict the efficient market model (based on
expected return) laid out above.

Lo and MacKinlay (1999) find that short-run serial correlations

exist between successive price changes, giving rise to the idea
that there is some momentum in short-run stock process that
technical analysts may be able to exploit. The field of behavioral
finance finds this phenomenon to be consistent with
psychological
feedback
mechanisms
(contagion)
where
individual players in the market are drawn into a kind of
bandwagon effect when they see a stock price rising. Another
explanation is a tendency to underreact to new information if
implications are understood only over time it may cause shortrun positive correlations to appear. Even so, momentum
investors will not tend to realize excess returns due to
transactions costs involved in exploitation, as discussed earlier.
Also, the key factor is whether patterns of serial correlation are
consistent over time many patterns seem to disappear after
they are published in finance literature!

Fama & French as well as Poterba & Summers (1988) found

evidence of long term mean reversion in stock market returns.
Some studies attribute this to a tendency of stock market
overreaction Debondt & Thaler (1995) say investors are prone
to waves of optimism/pessimism that cause prices to deviate
from their fundamental values that later shows up as mean
reversion when they return to normal. According to Kahneman
& Tversky (1982) this is consistent with behavioral decision
theory where investors are susceptible to systematic
overconfidence in their forecasting ability. These findings lend
some credibility to the contrarion investment strategy
buying stocks that have been out of favor for a time over stock
that have been performing considerably well over recent
periods. One way to reconcile this apparent anomaly is to
consider the effect of interest rates on stock which must move in
opposite direction to compensate and remain competitive. If
interest rates mean revert over time, this pattern will tend to
generate mean reversion in a way that is consistent with
efficient functioning of markets.

Predictable days of the week/season patterns such as the

January Effect, where returns have tended to be unusually high
during the first two weeks of the year particularly for stocks
with relatively small total market cap (Keim 1983). In addition
French (1980) documents significantly higher Monday returns
as well as around holidays (Ariel 1990). However these are not
dependable from period to period and hence do not offer
arbitrage opportunities hence do not necessarily negate the
efficient market hypothesis.

Wall Street traders often joke that now the January

effect is more likely to occur on the previous
Thanksgiving. - Malkiel

Depending on the forecast horizon, as much as 40% of the

variance of future returns for the stock market as a whole can
be predicted on the basis of the initial dividend yield of the
market index (Fama & French and Campbell & Shiller 1988).
Investors have earned a higher rate of return from the stock
market when they have purchased a market basket of equities
with an initial dividend yield that was relatively high and vice
versa. However the ability of initial yields to predict returns may
simply be the result of stock market adjustment to general
economic conditions. Besides, behavior of U.S. companies has
changed in the 21st century; they are more likely to repurchase
shares than increase dividends and thus dividend yield may no
longer be as meaningful as a useful predictor of future returns
as in the past.

Small firm-effect was demonstrated by Keim 1983 when he

showed that since 1926, small company stocks have produced
rates of return over one percentage point larger than the
returns from large company stocks. However dependability of
this size phenomenon is in question as it is possible that studies
of small-firm effect have been affected by survivorship bias a
researcher who examined 10 year performance of todays small
companies would be measuring for only those that survived not
those that failed.

Stocks with low price-earnings multiples (often called value

stocks) appear to provide higher rates of return than stocks with
high EPS (Nicholson 1960, Ball 1978 and Basu 1977). Such
results raise questions about efficiency of the market if one
accepts the capital asset pricing model, but these findings may
simply indicate failure of CAPM to capture all dimensions of risk
that are priced into the market. Fama and French (1993) argue
that a 3-factor asset-pricing model (including price-to-bookvalue and size as measures of risk) is the appropriate
benchmark against which anomalies should be measured.

The ease of experimenting with financial databanks of multiple

dimensions makes it quite likely that investigators will uncover
some seemingly significant but wholly spurious correlation
between financial variables. Given enough time and manipulation

of data series, it is possible to tease any kind of pattern out of most

data sets.
a true market inefficiency ought to be an exploitable
opportunity. If theres nothing investors can exploit in a
systematic way, time in and time out, then its very hard to
say that information is not being properly incorporated
into stock prices. Roll

THE KSE
Karachi Stock Exchange (Guarantee) Limited (KSE) was established
on September 18, 1947. It was incorporated on March 10, 1949. The
first index introduced in KSE was based on fifty companies and was
called KSE 50 index. In October 1970, under the Securities and
Exchange Ordinance of 1969 by the Government of Pakistan, a second
stock exchange was established in Lahore in response to the needs of
the provincial metropolis of the province of Punjab. Yet another stock
exchange known as Islamabad Stock Exchange was established in
Islamabad, the capital city of Pakistan on October 25, 1989 As a result
of the Stock Exchanges (Corporatization, Demutualization &
Integration) Act, 2012 (known as "Demutualization Act") the three
exchanges (KSE, LSE and ISE) were merged together to form a new
combined exchange called Pakistan Stock Exchange Limited (PSX)
which started its operations on January 11, 2016 under this new title.
As on June 3rd, 2016 there are 578 companies listed in PSX and the
total market capitalization is Rs. 7,516.393 billion in 35 sectors.
KSE 100 INDEX

The KSE-100 Index was introduced in November 1991 with base value
of 1,000 points. The Index comprises of 100 companies selected on
the basis of sector representation and highest free-float capitalization,
which captures over 80% of the total free-float capitalization of the
companies listed on the Exchange.
Free-Float is the proportion of total paid-up shares issued by a
company that are readily available for trading at a Stock Exchange.
Thirty five companies are selected i.e. one company from each sector
on the basis of the largest free-float capitalization and the remaining
65 companies are selected on the basis of largest free-float
capitalization in descending order.

This is a total return index i.e. dividend, bonus and rights are
adjusted. It is revised after every six months for inclusion or exclusion
of companies on the basis of above mentioned criteria.
The past performance data of the KSE, when viewed over one year
period shows some evidence of mean reversion in underlying stock
prices.

However, over an expanded 10 year period, the trend takes on an

increasing trend which seems to suggest that some form of efficiency
exists in the KSE, though this may only be weak-form as not a lot of
information is made publicly available in this developing economy.

REFERENCES

[1]Efficient Capital Markets: A review of theory and empirical work

Eugene F. Fama The Journal of Finance Vol. 25, 1970
[2]The Efficient Market Hypothesis and Its Critics Burton G.
Malkiel CEPS Working Paper No. 91, 2003
[3]http://www.ksestocks.com/AboutPSX
[4] http://www.tradingeconomics.com/pakistan/stockmarket/forecast