Abnormal Returns in Efficient and Inefficient Markets

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Efficient Capital Markets

According to Fama (1970), an efficient capital market is one in which stock prices fully re-flect available information. Further on he argues that in order for the market to be efficient, i.e. the prices are fully reflecting all available information, the following conditions must be fulfilled;
•There are no trading costs in trading securities.
•All available information is costless available to all market participants.
•All agree on the implications of current information for the current price and distribu-tions of future prices of each security.
Wramsby and Österlund (2005) argue that it also exists a fourth condition which needs to be fulfilled in order for the market to be efficient, namely that the investors are price takers. This implies that no private trader on the market is big enough to affect the price on for in-stance a stock. However, Fama (1970) argues that these conditions are sufficient for market efficiency, but not necessary, and in practice the markets do not work this way. For in-stance, as long as investors take all available information into account, despite large transac-tion costs, when the transaction do take place the security is argued to be priced “fully re-flecting” all available information according to Fama (1970). Ross et al., (2005) illustrates the efficiency arguing that a company releasing an announcement in the morning will im-mediately have affect on the stock price. There will be no possibility for an investor to buy the stock in the afternoon and make a profit the day after since the efficient market hy-pothesis predicts that the share price will be adjusted immediately after the announcement in the morning. They further argue that the efficient market hypothesis has implications for investors and firms. An investor should only expect to obtain a normal rate of return be-cause information is reflected in prices immediately, before the investor has time to trade on it. Firms selling securities should expect to receive a fair value, i.e. the present value, meaning that they can not fool investors by receiving more than that value. These are as-sumptions concerning an efficient market, i.e. all available information is immediately re-sponded to by the market. However, in reality different kinds of information may affect stock prices more quickly than other information. After further investigating the findingsof Fama (1970), Ross et al. (2005) separates information into three different types depend-ing on market response rates.

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The Weak Form

A capital market is weakly efficient when all information being used are past prices. His-torical information is the easiest kind of information and if it would be possible to make extraordinary profits by looking only at historical patterns, everyone would do it thus eliminating this possibility. (Ross et al., 2005)

The Semi strong Form

A capital market is semi strong efficient when prices are reflecting all publicly available in-formation. Publically available information is publicly released company reports, press re-leases, newspaper articles and historical price information. In a semi strong market the price of a stock should adjust immediately after new information has been released. (Ross et al., 2005)

The Strong Form

If a capital market is strongly efficient not only the above mentioned publicly available in-formation is included in the price but also private information. In a strong form efficient market an insider with private information about a company would not be able to profit from this information, i.e. any information with a value to the stock price known to at least one investor is fully incorporated into the present price. Empirical evidence shows that strong market efficiency does not exist in reality and the semi strong efficiency seems to be most common. (Ross et al., 2005)
The relationship between the three types of information can be illustrated with this figure;

Testing the efficiency of the market
Weak form test

As stated above, in a weakly efficient market one would be able to predict future stock prices by looking at historical price patterns. The random walk hypothesis is used to test whether a market is efficient in its weak form. The hypothesis implies that a stock’s histori-cal price movement is unrelated to future movements. Efficiency in its weak form can be tested mathematically with the following formula; Pt = Pt-1 + Expected return + Random errort
The formula states that the price of today equals the sum of the last observed price plus the expected return for the specific stock plus a random error component occurring over the interval. The random component is depending on new information on the stock and can thus be either positive or negative. The random component in one period is unrelated to the random component in any past period – it is thus unrelated to past prices and if stock prices follow this equation they follow a random walk. There is a consensus in previous lit-erature that this hypothesis holds meaning that markets are efficient in its weak form, meaning that there is no predictability of future stock prices from past prices. (Ross et al., 2005)

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Semi strong test

After extensive research supporting efficiency on the weak level, Fama (1970) extended his research to testing the speed of price adjustment to publicly available information, i.e. test-ing semi strong efficiency. This is usually done with an event study, testing that the released new information (annual earnings, change of CEO, new issues etc.) only effects the price of the stock at time t, and not before (t-1) or after (t+1) the new information is being re-leased. The abnormal return of a stock for a particular day is according to Ross et al. (2005) calculated by subtracting the market’s return from the return of the specific stock for the same day;
AR = R – Rm
Ross et al. (2005) further argues that in an efficient market previous information will al-ready be incorporated into the stock price, and what the market does not yet know, i.e. fu-ture information, can also not be reflected in the price today. If efficient, new information at time t will cause abnormal return at time t only. Event studies examines whether the re-lease of information causes abnormal returns only at day t or at other days as well, before or after the releasement. Fama (1970) points out that previous research on the semi strong form made on various types of public announcement’s affects on abnormal stock returns are all showing on efficiency on the semi strong level.

1 Introduction
1.1 Problem background
1.2 Problem Discussion
1.3 Purpose
1.4 Definitions
1.5 Demarcations of the study
2 Method
2.1 Research Approach
2.2 Data Collection
2.3 Selection
2.4 Data Diminution
2.5 Sign Test
2.6 Confidence Bounds for testing Abnormal Return
3 Frame of Reference
3.1 Efficient Capital Markets
3.2 Testing the efficiency of the market
3.3 Abnormal Returns in Efficient and Inefficient Markets
3.4 Market Reactions and Firm Size
3.5 The Swedish Stock Market
3.6 Information and trading with stocks
3.7 Previous Research
4 Empirical Findings and Analysis
4.1 Abnormal Return
4.2 Confidence Bounds for testing Abnormal Return
4.3 Sign Test of Market Efficiency
5 Concluding Remarks
5.1 Critique of the study
5.2 Suggestions for further research
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