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*The dollar return on Dreck is assumed to be held fixed as its price falls. Therefore,
Dreck™s rate of return will depend on the price to which its stock price falls, but in any
case the rate of return is not necessary to answer the question.

At any price for Dreck stock below $10 (1 1/70) $9.857, profits will be negative, which
means the arbitrage opportunity is eliminated. Note: $9.857 is not the equilibrium price of Dreck.
It is simply the upper bound on Dreck™s price that rules out the simple arbitrage opportunity.
6. Using Equation 7.8, the expected return is
4 (0.2 6) (1.4 8) 16.4%
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition



> Demonstrate why security price movements should be
essentially unpredictable.

> Cite evidence that supports and contradicts the efficient
market hypothesis.

> Formulate investment strategies that make sense in
informationally efficient markets.

Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

Related Websites
This site has an online journal entitled Efficient Frontier:
An Online Journal of Practical Asset Allocation. The http://www.businessweek.com/investor
journal contains short articles related to assessment of These sites contain information related to market
strategies. efficiency issues surrounding individual stocks as well
http://www.superstarinvestor.com/index.html as mutual funds.
This site contains many references to other sites that http://www.newyorkfed.org
have data on technical and fundamental analysis as
well as sites containing information on earnings and
investor conference calls.
These sites contain research reports and shorter
summaries of articles with information on various
aspects of market efficiency.

ne of the early applications of computers in economics in the 1950s was to

O analyze economic time series. Business cycle theorists believed tracing the
evolution of several economic variables over time would clarify and predict
the progress of the economy through boom and bust periods. A natural candidate for
analysis was the behavior of stock market prices over time. Assuming stock prices re-
flect the prospects of the firm, recurring patterns of peaks and troughs in economic
performance ought to show up in those prices.
Maurice Kendall (1953) was one of the first to examine this proposition. He
found to his great surprise that he could identify no predictable patterns in stock
prices. Prices seemed to evolve randomly. They were as likely to go up as they were to
go down on any particular day regardless of past performance. The data provided no
way to predict price movements.
At first blush, Kendall™s results disturbed some financial economists. They
seemed to imply that the stock market is dominated by erratic market psychology, or
“animal spirits,” and that it follows no logical rules. In short, the results appeared to
confirm the irrationality of the market. On further reflection, however, economists re-
versed their interpretation of Kendall™s study.
It soon became apparent that random price movements indicated a well-
functioning or efficient market, not an irrational one. In this chapter, we will explore
the reasoning behind what may seem to be a surprising conclusion. We show how
competition among analysts leads naturally to market efficiency, and we examine the
implications of the efficient market hypothesis for investment policy. We also consider
empirical evidence that supports and contradicts the notion of market efficiency.
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

262 Part TWO Portfolio Theory

Suppose Kendall had discovered that stock prices are predictable. Imagine the gold mine for
investors! If they could use Kendall™s equations to predict stock prices, investors would reap
unending profits simply by purchasing stocks the computer model implied were about to in-
crease in price and selling those stocks about to fall in price.
A moment™s reflection should be enough to convince you that this situation could not per-
sist for long. For example, suppose the model predicts with great confidence that XYZ™s stock
price, currently at $100 per share, will rise dramatically in three days to $110. All investors
with access to the model™s prediction would place a great wave of immediate buy orders to
cash in on the prospective increase in stock price. No one in the know holding XYZ, however,
would be willing to sell, and the net effect would be an immediate jump in the stock price to
$110. The forecast of a future price increase leads instead to an immediate price increase. An-
other way of putting this is that the stock price will immediately reflect the “good news” im-
plicit in the model™s forecast.
This simple example illustrates why Kendall™s attempts to find recurring patterns in stock
price movements were in vain. A forecast about favorable future performance leads instead to
favorable current performance, as market participants all try to get in on the action before the
price jump.
More generally, one could say that any publicly available information that might be used to
predict stock performance, including information on the macroeconomy, the firm™s industry,
and its operations, plans, and management, should already be reflected in stock prices. As
soon as there is any information indicating a stock is underpriced and offers a profit opportu-
nity, investors flock to buy the stock and immediately bid up its price to a fair level, where
again only ordinary rates of return can be expected. These “ordinary rates” are simply rates of
return commensurate with the risk of the stock.
But if prices are bid immediately to fair levels, given all available information, it must be
that prices increase or decrease only in response to new information. New information, by def-
inition, must be unpredictable; if it could be predicted, then that prediction would be part of
today™s information! Thus, stock prices that change in response to new (unpredictable) infor-
random walk mation also must move unpredictably.
This is the essence of the argument that stock prices should follow a random walk, that is,
The notion that stock
that price changes should be random and unpredictable. Far from being a proof of market ir-
price changes are
rationality, randomly evolving stock prices are the necessary consequence of intelligent in-
random and
unpredictable. vestors competing to discover relevant information before the rest of the market becomes
aware of that information.
Don™t confuse randomness in price changes with irrationality in the level of prices. If
prices are determined rationally, then only new information will cause them to change.
Therefore, a random walk would be the natural consequence of prices that always reflect all
current knowledge.
Indeed, if stock price movements were predictable, that would be damning evidence of stock
market inefficiency, because the ability to predict prices would indicate that all available infor-
efficient market
mation was not already impounded in stock prices. Therefore, the notion that stocks already re-
flect all available information is referred to as the efficient market hypothesis (EMH).
The hypothesis that Figure 8.1 illustrates the response of stock prices to new information in an efficient market.
prices of securities
The graph plots the price response of a sample of 194 firms that were targets of takeover at-
fully reflect available
tempts. In most takeovers, the acquiring firm pays a substantial premium over current market
information about
prices. Therefore, announcement of a takeover attempt should cause the stock price to jump.
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

8 The Efficient Market Hypothesis

F I G U R E 8.1
Cumulative abnormal return, %
Cumulative abnormal
returns surrounding
32 takeover attempts:
Target companies.
Returns are adjusted
24 to net out effects of
broad market
16 Source: Arthur Keown
and John Pinkerton,
12 “Merger Announcements
and Insider Trading
8 Activity,” Journal
of Finance 36
(September 1981).




135 120 105 90 75 60 45 30 15 0 15 30
Days relative to announcement date

The figure shows that stock prices jump dramatically on the day the news becomes public.
However, there is no further drift in prices after the announcement date, suggesting that prices
reflect the new information, including the likely magnitude of the takeover premium, by the
end of the trading day.
An even more dramatic demonstration of the speed of price response appears in Figure 8.2.
Suppose that you bought shares of firms announcing positive earnings surprises and sold short
shares of firms with negative earnings surprises. (A positive surprise is defined as earnings
that exceed the prior forecast published by the Value Line Investment Survey.) The figure
tracks the average profits to this strategy for each half-hour period following the public an-
nouncement. The figure demonstrates that the vast majority of the profits to this strategy
would be realized in the first half-hour following the announcement. Only 30 minutes after the
public announcement, it is virtually too late to profitably trade on the information, suggesting
that the market responds to the news within that short time period.

Competition as the Source of Efficiency
Why should we expect stock prices to reflect all available information? After all, if you were
to spend time and money gathering information, you would hope to turn up something that
had been overlooked by the rest of the investment community. When information costs you
money to uncover and analyze, you expect your investment analysis to result in an increased
expected return.
Investors will have an incentive to spend time and resources to analyze and uncover new
information only if such activity is likely to generate higher investment returns. Therefore, in
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

264 Part TWO Portfolio Theory

F I G U R E 8.2 25
Returns following
earnings 20
Note: Only the return in the 15
first 30 minutes was
Return (%)

statistically significantly
different from that of a
control sample at 5 or 10%
confidence levels. 5
Source: James M. Patell and
Mark A. Wolfson, “The
Intraday Speed of Stock
0“30 30“60 60“90 90“120 120“150 150“180
Prices to Earnings and
Dividend Announcements,” 5
Journal of Financial
Economics, June 1984,
pp. 223“52.
Minutes since public announcement


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