CHAPTER 6
EFFICIENT CAPITAL MARKETS
Answers to Questions
1.
There are several reasons why one would expect capital markets to be efficient, the foremost
being that there are a large number of independent, profitmaximizing investors engaged in
the analysis and valuation of securities. A second assumption is that new information comes
to the market in a random fashion. The third assumption is that the numerous profit
maximizing investors will adjust security prices rapidly to reflect this new information.
Thus, price changes would be independent and random. Finally, because stock prices reflect
all information, one would expect prevailing prices to reflect “true” current value.
Capital markets as a whole are generally expected to be efficient, but the markets for some
securities might not be as efficient as others. Recall that markets are expected to be efficient
because there are a large number of investors who receive new information and analyze its
effect on security values. If there is a difference in the number of analysts following a stock
and the volume of trading, one could conceive of differences in the efficiency of the markets.
For example, new information regarding actively traded stocks such as IBM and Exxon is
well publicized and numerous analysts evaluate the effect. Therefore, one should expect the
prices for these stocks to adjust rapidly and fully reflect the new information. On the other
hand, new information regarding a stock with a small number of stockholders and low
trading volume will not be as well publicized and few analysts follow such firms. Therefore,
prices may not adjust as rapidly to new information and the possibility of finding a
temporarily undervalued stock are also greater. Some also argue that the size of the firms is
another factor to differentiate the efficiency of stocks. Specifically, it is believed that the
markets for stocks of small firms are less efficient than that of large firms.
2.
The weakform efficient market hypothesis contends that current stock prices reflect all
available securitymarket information including the historical sequence of prices, price
changes, and any volume information. The implication is that there should be no relationship
between past price changes and future price changes. Therefore, any trading rule that uses
past market data alone should be of little value.
The two groups of tests of the weakform EMH are (1) statistical tests of independence and
(2) tests of trading rules. Statistical tests of independence can be divided further into two
groups: the autocorrelation tests and the runs tests. The autocorrelation tests are used to test
the existence of significant correlation, whether positive or negative, of price changes on a
particular day with a series of consecutive previous days. The runs tests examine the
sequence of positive and negative changes in a series and attempt to determine the existence
of a pattern. For a random series one would expect 1/3(2n  1) runs, where n is the number of
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 One '10
 LeeJohn
 Financial Markets

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