26-08-2014, 04:18 PM
Market Rationality Efficient Market Hypothesis versus Market Anomalies Project Report
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Abstract
Market efficiency theory suggests that market is rational and provides correct
pricing. That is, the current prices of securities are close to their fundamental values
because of either the rational investors or the arbitragers’ buy and sell action of
underpriced or overpriced stocks. On the other hand, observed market anomalies
have a challenge for this argument. They claim that irrational investment activities and
the arbitrage opportunities’ being limited in markets cause some market anomalies
that are inconsistent with efficient market hypothesis. The most commonly seen
anomalies are the “volume”, “volatility”, “cash dividends”, “equity premium puzzle”,
and the “predictability”.
This work is a literature survey, and its main objective is to deal with efficient
market theory and market anomalies in order to examine the question “Are markets
rational or not"?
Introduction
According to the traditional finance, markets are “rational”; that is, they are
efficient in the sense to reflect the correct prices supporting the efficient market
hypothesis. On the other hand, behavioral finance argues about this kind of market
rationality with the observed market anomalies that are not explained by the
arguments of the efficient market hypothesis. Many researchers including DeBondt
and Thaler (1985), Black (1986), De Long et al. (1990), Shleifer and Vishny (1995),
Thaler (1987, 1999), etc. exhibited many observed market anomalies. However,
despite many observed market anomalies, the efficient market hypothesis is still the
dominant paradigm in order to organize and rule the markets. In this sense, the aim of
this study is to deal with efficient market theory and market anomalies in order to
examine the question “are markets rational or not"? Because if markets are not rational
as traditional finance presumes, all the market rules, dynamics and mechanisms have
to be questioned.
The paper will begin with a history of the market efficiency from the start of
random-walk theory and the forms of the efficient market hypothesis. Next, the
arguments about the concept of arbitrage which is one of the main important
assumptions of market efficiency will be elaborated. Finally, observed market
anomalies that are not explained by the arguments of the efficient market hypothesis
will be presented
The Forms of the Market Efficiency
In the definition of the “relevant information set” that prices should reflect, Fama
distinguished three nested information sets: past prices, publicly-available information, and
all information including private information (Kondak, 1997:36). Efficient market hypothesis
is divided into three stages as the weak form, semi-strong form, and the strong form with
respect to the availability of the above mentioned three information sets.
Weak form of efficiency claims that the current stock prices already reflect all
historical market data such as the past prices and trading volumes (Bodie et al., 2007).
The assertion of weak form of efficiency is very much consistent with the findings of
researches on random walk hypothesis; that is, the price changes from one time to
another are independent (Dixon et al., 1992). In other words, one can not make a
superior profit by only examining the historical prices information. Therefore, the
technical (trend) analysis which is a technique using the derivation of past price
movements in order to find out a meaningful sign to predict the future path of an
individual stock or stock market itself is useless (Jones, 1993). However, one can beat
the market and make superior profits in the weak form of efficient market by using the
fundamental analysis or by insider trading.
Market Efficiency and the Arbitrage
The efficient market hypothesis has three basic assumptions. First, investors are
rational; that is, they value the securities with respect to their fundamental value. As
discussed at the previous section, when investors learn something about a security,
they immediately reflect this knowledge to the price of that security. Second, some
investors may be irrational; however, their investing activities are in the random
fashion and uncorrelated; therefore, their trading cancels each other without affecting
the price. The logic behind this assumption is that investors’ trading activities are
poorly correlated with each other. Third, if they are highly correlated with each other,
The Market Anomalies
There are many observed market movements that are not explained by the
arguments of the efficient market hypothesis. In the standard finance theory, such
market movements that are inconsistent with the efficient market hypothesis are called
anomalies (Bostancı, 2003). According to Tversky and Kahneman (1986:252) “an
anomaly is a deviation from the presently accepted paradigms that is too widespread
to be ignored, too systematic to be dismissed as random error, and too fundamental to
be accommodated by relaxing the normative system”.
Volatility
In the standard finance theory, the value of a stock is found by discounting its
expected future dividends to present. From the efficient market point of view, the price
of a security changes only when there is dividend expectation or when new
information has arrived. However, there are too many cases of excess volatility
observed in stock markets that could not explained by market efficiency perspectives
(Oran, 2008). LeRoy and Porter (1981) and Shiller (1981) studied S&P 500 Index, DJIA
and some blue chip stocks and showed that the volatility in securities is five to thirteen
times higher than the changes in present value of future dividends
Cash Dividends
According to Black (1986), dividend policy is a tool through which managers
can communicate with company’s shareholders especially for the things that they do
not want to say sharply and quickly. Therefore, it has been always an important
indicator for the determination of market price. The commonly used dividend policies
are cash-dividend, stock-dividend, stock-splits and stock-repurchase plans (Brealey et
al., 1999). According to Miller and Modigliani (1961), dividend policy is irrelevant in
determining the value of the company and its stock price under the no tax world
assumption. Unfortunately, we do not have this kind of “perfect world”; on the contrary,
tax concerns always exist. At this point, the cash-dividend anomaly occurs. That is, if
the company wants to give stock to its shareholders as dividends and if the
shareholders want to realize their gains by selling the stock, then it is subject to capital
gain. It is valid both for the stock-splits and stock-repurchases by the company.
Moreover, capital gains are subject to tax only when realization happens. However, in
most countries, cash dividends are subject to higher income tax rates than capital gain.
Nonetheless, cash dividends are more preferable than others despite higher tax
disadvantage (Miller, 1986). Moreover, when the company announces a cash dividend
program, its stock price rises (Long, 1978). While, whether the reason for this is
market inefficiency is highly controversial, it remains as an anomaly and needs to be
answered (Thaler, 1999).
Conclusion
There is no question about the existence of empirically observable market
anomalies. Even, Fama (1991) accepts their existence. The question is whether these
occur because of inefficiency of the market or some other problems and by chance. It
is easy to discover an anomaly inconsistent with the efficient market hypothesis;
however, highly difficult to explain the reason for their occurrence. Two views have
been proposed to explain the anomaly. One side lead by Fama and French (1998)