Financial Markets and Institutions (2-downloads)

efficient market hypothesis (also referred to as the theory of efficient capital

markets), which states that prices of securities in financial markets fully reflect all

available information. But what does this mean?

You may recall from Chapter 3 that the rate of return from holding a security

equals the sum of the capital gain on the security (the change in the price) plus

any cash payments, divided by the initial purchase price of the security:

(1)

where

R = rate of return on the security held from time t to time t + 1 (say, the

end of 2011 to the end of 2012)

P

t + 1

= price of the security at time t + 1, the end of the holding period

P

t

= the price of the security at time t, the beginning of the holding period

C = cash payment (coupon or dividend payments) made in the period t

to t + 1

Let’s look at the expectation of this return at time t, the beginning of the hold-

ing period. Because the current price and the cash payment C are known at the begin-

ning, the only variable in the definition of the return that is uncertain is the price next

period, P

t+ 1

.

1

Denoting the expectation of the security’s price at the end of the hold-

ing period as 

, the expected return R

e

is

The efficient market hypothesis views expectations as equal to optimal forecasts

using all available information. What exactly does this mean? An optimal forecast is

the best guess of the future using all available information. This does not mean that

the forecast is perfectly accurate, but only that it is the best possible given the avail-

able information. This can be written more formally as

which in turn implies that the expected return on the security will equal the opti-

mal forecast of the return:

R

e

= R

of

(2)

Unfortunately, we cannot observe either R

e

or 

, so the equations above by

themselves do not tell us much about how the financial market behaves. However,

if we can devise some way to measure the value of R

e

, these equations will have

important implications for how prices of securities change in financial markets.

P

e

t

⫹1

P

e

t

⫹1

⫽ P

of

t

⫹1

R

e

⫽

P

e

t

⫹1

⫺ P

t

⫹ C

P

t

P

e

t

⫹1

R

⫽

P

t

⫹1

⫺ P

t

⫹ C

P

t

Chapter 6 Are Financial Markets Efficient?

117

1

There are cases where C might not be known at the beginning of the period, but that does not

make a substantial difference to the analysis. We would in that case assume that not only price expec-

tations but also the expectations of C are optimal forecasts using all available information.

Access

www.investorhome

.com/emh.htm

to learn

more about the efficient

market hypothesis.

G O   O N L I N E

---

118

Part 2 Fundamentals of Financial Markets

The supply-and-demand analysis of the bond market developed in Chapter 4

shows us that the expected return on a security (the interest rate in the case of the

bond examined) will have a tendency to head toward the equilibrium return that

equates the quantity demanded to the quantity supplied. Supply-and-demand analy-

sis enables us to determine the expected return on a security with the following equi-

librium condition: The expected return on a security R

e

equals the equilibrium return

R*, which equates the quantity of the security demanded to the quantity supplied;

that is,

R

e

= R* (3)

The academic field of finance explores the factors (risk and liquidity, for example)

that influence the equilibrium returns on securities. For our purposes, it is suffi-

cient to know that we can determine the equilibrium return and thus determine the

expected return with the equilibrium condition.

We can derive an equation to describe pricing behavior in an efficient market

by using the equilibrium condition to replace R

e

with R* in Equation 2. In this way

we obtain

R

of

= R* (4)

This equation tells us that current prices in a financial market will be set so that