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How to test for market efficiency.

FIN 352 – Professor Dow. How to test for market efficiency. How to test?. Fama : Test the efficient market hypothesis using different information sets. Three categories : Weak Semi-Strong Strong Some tests directly use this categorization, others do not. Weak form efficiency.

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How to test for market efficiency.

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  1. FIN 352 – Professor Dow How to test for market efficiency.

  2. How to test? • Fama: Test the efficient market hypothesis using different information sets. • Three categories: • Weak • Semi-Strong • Strong • Some tests directly use this categorization, others do not.

  3. Weak form efficiency • All past-price information is fully reflected in stock prices. • Can’t use past prices to forecast future prices. • If true, technical analysis is not useful.

  4. Semi-Strong Efficiency • All public information is fully reflected in stock prices. • If true, fundamental analysis is not useful.

  5. Strong Form Efficiency • All information is reflected in stock prices. • Implies that trading on insider information shouldn’t be profitable. • Not true • But not legal

  6. Examples of tests • A) Patterns in stock prices. • B) Back-testing trading rules. • C) Do categories of stocks earn abnormal returns? • D) Event studies. • E) Do stock prices move “too much?” • F) Bubbles. • G) Do some investors outperform the market?

  7. A) Patterns in Stock Prices • Serial Correlation > 0, Momentum • Serial Correlation < 0, Mean Reversion • Serial Correlation = 0, Random Walk • Weak Form EMH predicts random walk

  8. B) Backtesting Trading Rules • See if trading rules are profitable when applied to historical stock price data. • Data Mining • In-Sample vs. Out-of-Sample

  9. C) Do some types of stocks earn abnormal returns • Value stocks • Small stocks • Or is it microcap/neglected stocks? • Is it is risk premium?

  10. D) Event Studies • Abnormal returns: Stocks earn greater returns than they “should”: Ri – E(R) • Theory implies that stocks should earn abnormal returns when news first comes out, but not afterwards (stock prices are quick to adjust to news) • Book gives example where they use excess returns (Ri-Rm) to measure response to event. Response is slower than it should be.

  11. E) Bubbles • Increases in asset prices not justified by “fundamentals” • At some point, bubbles pop! • Shouldn’t have bubbles if markets are efficient. • Recent experience with real estate and stock price bubbles.

  12. F) Do stock prices move “too much” • Theory: Stock price is the present value of expected future dividend payments. • Stock prices shouldn’t vary more than dividends or earnings do. • But there is more variation • Similar idea to bubbles: stock prices move based on psychological reasons rather than fundamental reasons.

  13. G) Do some investors outperform others? • Why do some investors do well? • Luck • Higher risk • Skill • Mutual funds tests

  14. What do we know • Markets are broadly efficient, but some important exceptions. • Bubbles • Some people understand the economy better – but do you?

  15. Implications for investing • Build around index funds: Well-diversified and low cost • Do bubbles imply market timing? • Do you want to engage in fundamental analysis?

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