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Chapter 8. Efficient Market Hypothesis . The Efficient Market Hypothesis (EMH). A market is efficient if prices “fully reflect” available information and adjust rapidly to new information .
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Chapter 8 Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) • A market is efficient if prices “fully reflect” available information and adjust rapidly to new information. • In an efficient market, public information cannot be used to earn above-market returns after adjusting for risk.
EMH • In an efficient market, security prices fairly reflect all that is known by investors. • An efficient market is a “fair game” as long as information is equally available.
EMH and “Random Walk” If a market is efficient, price levels are not random; price changes are random (cannot be predicted). Why would price changes be random? • Prices react to new information • Information is new only if it is not expected
Forms of the EMH 1. Weak form 2. Semi-strong form 3. Strong form • These vary with respect to the set of information
Weak Form of EMH A market is weak-form efficient if prices fully reflect market data.
Weak Form of EMH • Technical Analysis –using patterns in market data to predict price changes. • If the stock market is weak-form efficient, can technical analysis benefit investors?
Semistrong Form EMH • A market is semistrong efficient if prices fully reflect all public information.
Semistrong Form EMH • Fundamental Analysis –using economic and accounting information to evaluate a security. • If the stock market is semistrong form efficient, can fundamental analysis benefit investors?
Strong Form EMH • A market is strong form efficient if prices fully reflect all information, public and private. • If the stock market is strong form efficient, do insiders have an advantage over other investors?
Investment Strategy in Efficient Market If you believe markets are efficient (with respect to you): Diversify broadly Match portfolio risk to your risk tolerance Buy & hold
Inefficient Market Investment Strategy If you believe markets are inefficient: Try to beat the market by identifying undervalued securities or sectors & overweighting.
Evidence regarding EMH • To interpret the evidence on EMH, we must distinguish between statistical significance and economic significance. • The key issue is whether or not investors can earn above-market rates of return without taking on above average risk.
Tests of Weak Form Efficiency • The evidence is generally consistent with weak form efficiency in securities markets. Most studies conclude that technical analysis is not profitable.
Tests of Semistrong Efficiency • The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information.
Tests of Semi-strong Form: Anomalies • While most evidence supports semistrong efficiency, several price patterns are inconsistent with semistrong efficiency (“anomalies”).
Tests of Semi-strong Form: Anomalies • An “anomaly:” something that deviates from what is believed to be true. • Stock market anomalies: • Small firm effect (Fig. 8.3, p. 241) • Book-to-Market ratios (Fig. 8.4, p. 242)
Implications of Test Results • Risk Premiums or market inefficiencies? • Evidence of a past pattern of stock returns is not enough: is there any reason to believe the pattern will persist in the future?