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Chapter 8

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

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  1. Chapter 8 Efficient Market Hypothesis

  2. 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.

  3. 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.

  4. 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

  5. Forms of the EMH 1. Weak form 2. Semi-strong form 3. Strong form • These vary with respect to the set of information

  6. Weak Form of EMH A market is weak-form efficient if prices fully reflect market data.

  7. 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?

  8. Semistrong Form EMH • A market is semistrong efficient if prices fully reflect all public information.

  9. 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?

  10. 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?

  11. 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

  12. Inefficient Market Investment Strategy If you believe markets are inefficient: Try to beat the market by identifying undervalued securities or sectors & overweighting.

  13. 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.

  14. 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.

  15. Tests of Semistrong Efficiency • The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information.

  16. Tests of Semi-strong Form: Anomalies • While most evidence supports semistrong efficiency, several price patterns are inconsistent with semistrong efficiency (“anomalies”).

  17. 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)

  18. 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?

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