Articles on Market Efficiency
Jun 6, 2011
Q & A
What is the relation, if any, between the practice of "front running" trades and the efficient market hypothesis?
(Read the full entry)
Nov 16, 2010
Videos
EFF: I was interviewed on Bloomberg Television's "InsideTrack" this past Friday about the efficient markets hypothesis (EMH), financial regulation, and capital requirements for banks.
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Jul 14, 2010
Q & A
To what extent do the limits of arbitrage (Schleifer and Vishny, 1997) discredit the idea of market efficiency?
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Jun 1, 2010
Videos
EFF: I was interviewed on CNBC's "Squawk Box" this past Friday about the recent financial crisis and financial regulatory reform.
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Nov 17, 2009
Q & A
Is the absence of a meaningful premium for US long-term bonds relative to short-term bonds evidence of market inefficiency? Does this relation hold in other global bond markets?
EFF: Unfortunately, we need long periods of data to do the relevant tests, and we do not have good long-term data on bond markets outside the U.S. For the U.S. we only have good long-term data (from CRSP) for Government bonds.
Tests on the U.S. data do not indicate that the small average premiums observed in the returns on long-term versus short-term Government bonds are badly out of line with the predictions of asset pricing models. The models do not predict big differences in the returns on long-term and short-term governments, and the observed premiums are statistically consistent with the models. The same is true for the rather small premiums of corporate bond returns over Government bond returns. Is the absence of a meaningful premium for US long-term bonds relative to short-term bonds evidence of market inefficiency? Does this relation hold in other global bond markets? (Read the full entry)
Nov 4, 2009
Q & A
Justin Fox ("The Myth of the Rational Market") and many other financial writers claim that much of the blame for the financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation. Is this a fair assessment? If so, how should policymakers respond?
EFF: The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s.
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Oct 2, 2009
Videos
From the American Finance Association's "Masters in Finance" video series, Eugene F. Fama presents a brief history of the efficient market theory. The lecture was recorded at the University of Chicago in October 2008 with an introduction by John Cochrane.
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Sep 17, 2009
Q & A
If a growing percentage of market participants pursued passive investment strategies, at what point would market efficiency break down? Is this a practical concern?
EFF/KRF: This is a complicated question that we address at length in "Disagreement, Tastes, and Asset Prices" (Journal of Financial Economics 2007). The answer depends to some extent on who turns passive. If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.
Aug 31, 2009
Q & A
Richard Thaler observes "Efficient market guys have to be willing to claim that the NASDAQ is efficiently priced at 5,000 and at 1,400. That's a tough sell." Comments?
EFF: Stock prices depend on two factors: expected profitability and the expected returns investors require to hold stocks. Both can vary dramatically through time. Thus, widely different levels of the market at different times are quite consistent with market efficiency. Indeed, they are required for market efficiency. This might well be a tough sell, but it's Finance 101.
KRF: Dick is referring to the behavior of stock prices during the tech boom and bust of 1995-2001. Gene is certainly right that market efficiency requires prices to adjust to new information about future cashflows and discount rates. (Read the full entry)
Aug 11, 2009
Videos
Widely cited as the father of the efficient market hypothesis and one of its strongest advocates, Professor Eugene Fama examines his groundbreaking idea in the context of the 2008 and 2009 markets. He outlines the benefits and limitations of efficient markets for everyday investors and is interviewed by the Chairman of Dimensional Fund Advisors in Europe, David Salisbury.
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Aug 6, 2009
Links
KRF: Professor Robert Lucas of the University of Chicago has an interesting guest article in The Economist, "In defense of the dismal science."
Aug 4, 2009
Q & A
Index funds buy stocks "blind" without regard to company fundamentals. Do their activities contribute to mispricing of securities?
EFF: Index funds typically buy cap-weighted portfolios so they do not contribute to mispricing. KRF: We analyze a general version of this question in "Disagreement, Tastes, and Asset Pricing" (Journal of Financial Economics, 2007). Suppose index fund investors hold a passive market portfolio. Then from a pricing perspective they are sitting on the sideline. They are not overweighting or underweighting any securities, so they do not affect (relative) prices. As a result, it is hard to argue that they contribute to mispricing. (Read the full entry)
Jul 27, 2009
Q & A
Firms often pay a substantial premium to the market price when making acquisitions. Does their willingness to pay a premium suggest the shares of target firms were mispriced?
EFF: The empirical evidence says that all the gains from mergers are eaten up in the premiums paid to acquire firms. On average, the acquiring firm gets nothing. This doesn't necessarily imply that the shares of the acquired firm were mispriced since there can be synergies (real business gains) from mergers. KRF: Takeover premiums do not imply that the target firms were mispriced. Since we do not expect the market to accurately forecast every acquisition that will create value, we should not be surprised that prices rise when tender offers and mergers are announced.
Apr 29, 2009
Q & A
George Soros claims (in his op-ed in the Wall Street Journal) that the Efficient Market Hypothesis is invalid, because prices in financial markets "always provide a biased view of the future, and that distortions of prices in financial markets may affect the underlying reality." Thoughts?
EFF: All the evidence I know says that market predictions are unbiased. It's understandable, however, that hedge fund managers are immune to this evidence since it's a threat to their existence.
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Mar 18, 2009
Q & A
What is the role of various derivatives instruments in maintaining an efficient market?
EFF: Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies. Whether this actually happens is a difficult, perhaps impossible, empirical question. The "problem" is that markets seemed rather efficient before Black-Scholes (which initiated the derivatives industry), so there wasn't much for derivatives to do.
(Read the full entry)Feb 23, 2009
Q & A
It seems obvious now that firms facing extreme financial difficulty should be avoided.
EFF: This is a market efficiency question. If firms facing extreme financial difficulty are properly priced to take account of the risks they face, there is no reason to avoid them, unless you don't like the risks.
KRF: Whenever you think about a proposition like this, you should ask yourself, "What do you know that the market doesn't?" Does the market know the firms are facing extreme difficulty? If so, your best bet is that the price is right. This does not mean that the price is always right, or even that the market always incorporates all publicly available information. Sure the price of a distressed firm may be too high, but it is equally likely it is too low. To decide how the market has erred in a specific case, you have to know more than the market or you need a better model than the market. Although most investors seem to think they have the expertise to beat the market, an enormous amount of empirical evidence says this is a very high bar.
Jan 19, 2009
Q & A
The Dow peaked around 14K in October 2007, one year later the Dow went to 7500. Was the market really in equilibrium last October given that it was on the verge of such a steep collapse? How can one address equilibrium given the daily volatility we are experiencing?
EFF: Every market determined price is an equilibrium price that should take account of all information available at the time the price is set. (This is the definition of market efficiency.) But things inevitably change, and equilibrium prices change along with them. All we can say about the recent market turmoil is that the volatility of information and its implications for forecasts of profitability must be quite high.
KRF: Market efficiency does not imply prices cannot change. It does not even say they cannot change by a lot. The key question is whether we should have known the Dow would drop from 14,000 to 7500. Some who made fortunes by anticipating the drop seem to have convinced many observers that the outcome was obvious, but that is just history being written by the victor. Unlike the technology boom of 1999-2000, I don't recall lots of conversations in which people struggled to understand why the Dow was at 14,000.
Dec 31, 2008
Q & A
Is the market turmoil a sign that markets are not efficient?
EFF/KRF: The market turmoil is caused by some combination of (i) quickly fluctuating changes in expected cashflows (future profitability), and (ii) variation in investor risk aversion that leads to variation in expected returns (the discount rates for expected cashflows). Both responses can be rational. In short, a change in volatility, by itself, says nothing about market efficiency. Of course, it is interesting to ask why the volatility of expected cashflows and expected returns increased so much, but that requires a much longer analysis.
ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R.
McCormick Distinguished
Service Professor of
Finance at the University
of Chicago Booth School
of Business
Kenneth R. French
The Roth Family Distinguished Professor of
Finance at the Tuck
School of Business at
Dartmouth College
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Dimensional Fund Advisors Ltd. is authorised and regulated in the United Kingdom by the Financial Services Authority (FRN: 150100), is registered in England and Wales under Company No. 02569601 and VAT No. 577327607. The registered office address of Dimensional Fund Advisors Ltd. is 7 Down Street, London, W1J 7AJ, United Kingdom. Dimensional Fund Advisors Ltd. is a subsidiary of Dimensional Fund Advisors.