"It is clear from classic arguments that the market can't be fully efficient. If it were, everybody would go home. There has to be some kind of stasis where the market is pretty efficient but not perfectly efficient." - J. Doyne Farmer (chaos theorist)

M07555  International Investment and Finance Oxford Brookes University  

Table of Contents

I.  Table of Figures  3

1.  Introduction  4

2.  The Theory of Market Efficiency  4

2.1  Forms of information efficient markets  5

2.1.1  Weak Form  5

2.1.2  Semi-strong Form  5

2.1.3  Strong Form  6

2.2  Asset Pricing  6

2.2.1  Capital Asset Pricing Model (CAPM)  6

2.2.2  Arbitrage Pricing Theory (ABT)  7

3.  Recent Development in the US and UK Stock Markets  8

3.1.  The Bubble  8

3.  From Efficient Market Theory to Behavioural Finance  12

3.1  unrealistic Assumptions in CAPM  13

3.2  Evidence for additional Factors  14

3.2.1  Seasonal Effects  14

3.2.2  Size Effects  14

3.2.3  Value Effect  14

3.2.4  Momentum Effect  15

3.3  Behavioural Approach  15

4.  Alternative Theories in Asset Pricing  15

4.1  Model of Investor Sentiment  16

4.2  Overconfidence Model  17

5.  Conclusion  17

II.  Table of Literature  19

II.a  Reference List  19

II.b  Table of Websites  20

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M07555 International Investment and Finance Oxford Brookes University

I. Table of Figures

Figure 1: Nasdaq 100, Nasdaq Computer 1993-2003 Source: Onvista AG [online] www.onvista.de (URL:n.a.) [accessed 05.03.2003] Figure 2: Qualcomm Inc.Shares 1993-2003 Source: Onvista AG [online] www.onvista.de (URL:n.a.) [accessed 06.03.2003] Figure 3: FTSE 100 and FTSE Infotech 1993-2003 Source: Onvista AG [online] www.onvista.de (URL:n.a.) [accessed 06.03.2003]

Figure 4: Comparison of US and UK Financial Market Data Source: Own spreadsheet, data provided by Onvista AG [Online] www.onvista.de (URL:n.a.) [accessed 05.03.2003] Figure 5:Deviation of Market Price from Fundamental Price Source: Shiller, Robert J., “Do stock prices move too much to be justified by subsequent movements in dividends?” American Economic Review, vol.71 (3) 1981: 421-36 [online] www.few.eur.nl/few/people/smant/meconomics/shiller.htm [accessed 09.03.2003]

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M07555 International Investment and Finance Oxford Brookes University

1. Introduction

Ever since in the history of stock markets, financial theorists try to understand how investors take decisions under uncertainty in order to value stocks precisely and predict their future returns. Their wish to develop a consistent model gave raise for various theoretical approaches and empirical examinations. This work tries to give a short overview on the traditional theory of asset pricing and discusses the need for a paradigm change due to the recent development in the US and UK stock markets.

2. The Theory of Market Efficiency

In 1884 Charles Do and Eddie Jones first published the Dow Jones Average Index (Achleitner, 1999). This index constructed of average share prices of selected US companies was the empirical database for Dows development of his approach to predict share prices, later named the Dow Theory. He supposed a cyclic development of share prices and therefore stated that the technical analyses of charts would give information on future share prices. He recognised general trends, momentum and trend reversals. This was the birth of technical analysis and the chartists approach. Later his work was advanced by Ralph Nelson Elliott (MarketScreen, 2000). He concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves. Since his intention was to find a model for general economic development, Elliott believed that all of man's activities, not just the stock market, were influenced by these identifiable series of waves. An outstanding academic contributing was made by Louis Bachelier in 1900. Examining the dynamics of price developments, he recognised the

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M07555 International Investment and Finance Oxford Brookes University

numerous factors involved in asset pricing. Therefore he concluded that no certain expectation is possible and that trading is a “Fair Game”. Later, his theory was modified in several papers and gave raise for the theory of the random walk. The level of information efficiency is of the essence within these approaches

2.1 Forms of information efficient markets

Generally, the Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. One of the most known classifications of market efficiency was published by Fama (Olsen et al., 1992 and Fama, 1970) in 1970 and 1991. He distinguished three levels of market efficiency.

2.1.1 Weak Form

The weak form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use in order to gain extra profits. Prices follow a random walk.

2.1.2 Semi-strong Form

The semi-strong form says that all publicly available information is fully reflected in securities prices. Therefore, the analysis fundamental data is not able to enable investors to be better than the market. Only insider trading would allow extra profits.

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