Question

1. Download and read “Racetrack betting and informed behavior” by Asch et al (Journal of Financial Economics, July 1982), then answer the following: (i) How does the use of racetrack betting data overcome the EMH joint hypothesis problem?

Answer 1

Financial markets efficiency was the primary concern of economists. For example, when maximized value was expected by traders, market efficiency required the expected return on investments should be identical across different assets. There are few asset markets that could offer different form ofinformation efficiencies for testing purposes since in such markets, assets such as securities and in fact most of which were infinitely lived and that the 'true' value underneath thereof did not come to the surface within a specified time frame for comparison to the prices. Hence,economists to test the efficiency had turned to settings which were not only less important in itself, but also more promising for experimental inquiry. Such setting was the market for racetrack betting.

thousands years ago, horse race betting has been a custom. Horse racing inmany countries are highly institutionalized, standardized and regulated by governmental authorities. Bettors place wagers on a closely controlled probabilistic events and the odds are determined by market forces of thecompetitive betting market. Bettors face both risk and uncertainty. In each race,different horses have different winning probabilities that cannot be known beforehand. A rational bettor will place abet on a horse that he/she believeswill win and the odds is somehow underestimate the willing probability. At the same time, the bettors need to bear risk. They can only make a profit if they make estimation more accurate than the market does. In order to increase the chance of make accurate estimation, they require gathering more information.In more extreme case, the bettors with access to monopolistic information may able to outperform the others.

Comforting in some sense was the finding that these betting markets showed a relatively high degree of efficiency.Market odds were good predictors of winning chances. Nevertheless, there was one vigorous finding which was contradictory to market efficiency: the favorite-longshot bias (for a brief illustration, refer to Thaler and Ziemba, 1988). The winning opportunities of horses with a high winning probability are often undermined by the implied winning probabilities of the market odds and vice versa for those with a low winning probability. It could be said there are actually too few bets placed on the favorites and too many on the long shots. The expected return per dollar bet was not equal across bets in the aftermath.

research paper concerning betting market efficiency and equity, he suggested three kinds of market efficiency tests differentiated by definition of using ‘available information’. He had used the approach to test weak efficiency correlated to available information with historical prices and returns. Regarding the tests of semistrong efficiency, public announcements was added to the set of available information and focused on whether the prices being fully reflected as soon as they were made. The third type of test,which was related to strong efficiency, it had studied the occurrence of specific subsets of market participants possessing monopolistic access to or control over specific information. Owing tothe differentiation in information accessibility, when referring to this last set of test, Dowie chose to refer to equity: ‘In other words, we will talk of a market as efficient to the extent that it passes the weak and semi-strong tests and equitable to the extent that it passes the strong test’.Similarly, researchers studying horserace betting markets might focus on information contained in past odds/prices (i.e.weak-form EMH), information provided by‘experts’ (i.e. semistrong-form EMH),and information held privately by“insiders” (i.e. strong-form EMH). Oppositions exist upon whether the betting markets were efficient in these three forms.Weak-form EMH stated that technical analysis of past/historical prices was worthless; semi-strong-form EMH stated that fundamental analysis of publicly available information was worthless;strong-form EMH suggested that allinformation including private information was worthless. Most studies done previously agreed on overall weak-form and semistrong-form market efficiency,however, the strong-from market efficiency was in doubt.

Conclusion

On the whole, researches focused on the predictability of stock returns from past returns and other variables by EMH. For the following researchers,they further work on the predictability of daily and weekly returns from past returns, but they come to similar conclusion as Fama. The others such as the result of predictability of long-horizon stock returns from past returns have been inconsistent. In latest development, researchers test on other variables such as D/P, E/P and term structure then give a more reliable result in predictability of returns.

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