The federal open market committee and the federal funds rate: A test of market efficiency

Document Type

Article

Publication Date

1-2012

Abstract

Using standard event study methodology from the finance literature, this study tested the semi-strong form efficient market hypothesis by analyzing the effects of the Federal Open Market Committee (FOMC) January 22, 2008 announcement of a 75 basis point cut in the Federal Reserve (Fed) rate on the risk adjusted rate of return on a sample of 50 bank stocks. Specifically, is it possible to earn an above normal return on a publicly traded stock when the FOMC announces a FED funds rate cut? According to the semi-strong form efficient market hypothesis, it is not possible to consistently outperform the market-appropriately adjusted for risk-by using public information such as FED fund rate cut announcements. This type of information should impound stock price sufficiently fast to disallow any investor to earn an above normal risk adjusted return. Using standard risk adjusted event study methodology with the market model, the study analyzed 10,761 observations for the event period from the 50 publicly traded banking firms comprising the majority of the total US bank market capitalization and the S&P 500 Index to examine the impact of the FED funds rate cut on stock price. Evidence here supports the bank sample's swift and positive risk adjusted rate of return reaction to the FED fund rate cut announcement. However, the study results fail to support the semi-strong form efficient market hypothesis in the strictest format since investors are able to earn an above normal return during the 10 day window following the announcement. Likewise, results suggest the possibility of trading on this information up to 8 days prior to the announcement.

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