Capital Market Efficiency

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The finance theory refers to three forms of capital market efficiency:

• Weak-form of efficiency

• Semi-strong form of efficiency

• Strong-form of efficiency.

Weak form of market efficiency

The security prices reflect all past information about the price movements in the weak form of efficiency. Hence the weal form of efficiency is referred to as the random walk hypothesis. An alternative method of testing the weakly efficient market hypothesis is to formulate the trading strategies using the security prices and compare their performance with the stock market performance. The capital market will be inefficient if the investor’s trading strategy could beat the market. Researchers have studied a large number of trading rules, and have concluded that it is not possible for investors to outperform the market.

Semi-strong form of market efficiency

In the semi-strong form of efficiency, the security prices reflect all publicly available information. This implies that an investor will not be able to outperform the market by analyzing the existing company-related or other relevant information available in, say the annual accounts or financial dailies/magazines (the economic tomes or business India). In fact, such publicly available information is already impounded in the current security prices.

Strong form of efficiency

In the strong form of efficiency the security prices reflect all published and unpublished, public and private information. This is a significantly strong assertion and empirical studies have not borne out the validity of the efficient market hypothesis in the strong form of efficiency. People with private or inside information have been able to outperform the market.

Illustration: Event study

You are employed by a finance company, and you have been assigned the responsibility of analysing the effect of an unannounced bonus issue of 1:1 for Maxima India Limited. You think that the market is efficient. The first thing which you do is to determine the equation for the expected return for Maxima’s shares. You choose weekly returns for a three-year period up to six weeks before the unannounced bonus issue. Using the market model, you obtain the following characteristic line for Maxima:

 rMAX = 0.022 + 1.3 rm

Where, rMAX is Maxima’s return and rm is the market return. If the market return is zero, Maxima’s return will be 2.2 percent. You found those six months before the event, the market return was 12.6 percent. You can calculate Maxima’s expected return as follows:

rMAX = 0.022 + 1.3 (0.126) = 0.186 or 18.6%

Maxima’s actual return was also 18.6 percent. Thus, there was no abnormal return:

Abnormal return = expected return – actual return

= 18.6% - 18.6% = 0

Similar calculations can be made for weekly periods and after event (bonus issue). The cumulative addition of abnormal returns will give CAR was 2.3 percent until the bonus announcement (in time 0). After the bonus issue was announced, CAR increased to about 4 percent and remained unchanged for each week during next six weeks. Maxima’s CARs increased in anticipation of the bonus issue at time 0. Once this information was incorporated in the share prices, there were no more changes in the prices. For any other new information, the share prices may adjust again.