Modern Finance, Efficient Market Hypothesis, Random Walk Hypothesis, and Empirical Evidence

Modern finance is the body of knowledge built on the pillars of the arbitrage principles of Miller and Modigliani, the portfolio principles of Markowitz, the capital asset pricing theory of Sharpe, Lintner, and Black, and the option-pricing theory of Black, Scholes, and Merton.

In modern finance theory, people are modelled as “rational,” whereas people are modelled as “normal” In behavioral finance. The two terms are not always at odds: rational behavior is usually described as maximizing behavior, and maximiz­ing behavior is quite normal (Statman, 1999-1 p. 20). When offered a free choice between a 10TL and a 20TL, both rational and normal people choose the 20TL.

Additionally, modern finance theory assumes that agents are rational and that the law of one price holds. Two important aspects of agents’ rationality are maximization of expected utility and Bayes­ian learning (Adam, 2002, p. 2). This implies, for example, that choices are time-consistent. From a market perspective, modern finance theory rests on the law of one price, which states that securities with the same payoff have the same price.

The critical question that should be empha­sized is whether or not the agents’ irrationalities affect market outcomes. If not, this point should not be taken into account by finance researchers. If some or even all market participants are irra­tional, it is possible that the market mechanism can offset the distorting effect of these individual irrationalities, thereby limiting their impact on prices and allocation. If the market can average out irrationalities dependent upon the structure of the observed behavior, unsystematic irrationali­ties can be absorbed more easily than systematic deviations from rational behavior (Glaser et al., 2003, pp. 2-3).

In a capitalist society, prices for goods and services play a central role in resource allocation. The strength of capitalism lies in its ability to make these prices reflect essential information so that resources are deployed efficiently.

The following is a classic example of this phe­nomenon. Consider a fishmonger whose price for fish changes every day in response to availability. These prices have a direct effect on the behavior of customers entering the shop: if the price is high they may choose to eat beef for dinner instead. In other words, the allocation of fish to the most efficient uses (in this case, to the people with the highest marginal utility of fish consumption) is accomplished by price changes. These price changes directly regulate the use of fish (Dow & Gorton, 1995, p.1). This is a very simple model about the market mechanism in an economy.

Now let us consider the equity capital market and its relation to the allocation of funds for capital investment.

First, the equity price is not a marginal value but an average value. The stock market price is a secondary market price: it values the firm as a whole rather than valuing its each simple investment marginally. The role played by the stock price in a stock market is similar to the fish market example only in the simple case where a newly organized firm issues equity for the first time to fund its investment. In this special case, if investors believe that the capital can be more efficiently deployed elsewhere, or if the expected returns on the project are insufficient to induce enough savings, then the price will be low and the project may not be undertaken. However, only an insignificant fraction of investment capital is raised in this way: the vast majority of investment is funded by retained earnings, by seasoned equity issues, or by new non-equity external financing, such as bank loans or bonds.

Second, decisions about the allocation of investment capital are generally delegated to managers with little or no ownership stake in the firm. Managers can decide on dividend policy, leverage, the timing of new issues of seasoned equity, and other securities. They therefore have discretion over the amount of funding available for investing in new assets. The problem of giving managers appropriate incentives is complicated by the fact that their decisions may have implica­tions for the long-term performance of the firm after they have left.

Third, the flow of information in a stock market may be bi-directional: the participants may learn about the quality of the managers’ decisions, but the manager may also want to learn the market’s valuation of prospective investments.

In a setting where consumers learn about product quality from the price, there may be two effects: consumers will infer the quality from the price, and then compare the price to their marginal valuation. In general, Rational Expectations Mod­els capture these two effects. At one extreme, the prices in the preceding fishmonger example have a direct allocative role and no indirect signalling role. When consumers are buying fish it is im­portant that the price reflects information, but the consumers care only about the price and do not need to infer the information that determines the price. In general, commodity prices may have both a direct allocative role and an indirect signalling role. For example, if consumers receive different private signals about the quality of the commodity, the price will convey information about quality as well as information about scarcity. In Rational Expectations Equilibrium, an agent’s demand for the fish will depend on the price through this qual­ity inference. They argued that secondary equity prices are at the opposite extreme of fishmonger’s prices: they have an indirect signalling role but no direct allocative role (Dow & Gorton, 1995, p.

At this point, these special features of the equity market raise the question of whether “ef­ficient” stock prices are related to the efficient allocation of resources. The two definitions of market efficiency are as follows (Timmermann & Granger, 2004, p. 16):

A market is efficient with respect to information set Ω_t if it is impossible to make economic profits by trading on the basis of information set Ω_t.

A closely related definition of market ef­ficiency is:

A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some informa­tion set, Ω_t, if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an informa­tion set, Ω_t, implies that it is impossible to make economic profits by trading on the basis of Ω_t

After giving these two brief, but famous defini­tions of market efficiency, this paper will discuss Fama’s Efficient Market Hypothesis (EMH) in detail in the following subsection.

There is large body of research in literature on welfare economics, and an equally large body on efficient markets theory. However, there has been relatively little work linking these two literatures. By and large, welfare economists have not studied corporate control or asset pricing, while efficient­markets researchers have taken for granted that informational efficiency implies economic ef­ficiency. For example, Fama said:

An efficient capital market is an important compo­nent of a capitalist system... if the capital market is to function smoothly in allocating resources; prices of securities must be good indicators of value.