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The Efficient Markets Hypothesis

The Efficient Markets Hypothesis . Review of Empirical Financial Economics. Stephen J. Brown NYU Stern School of Business. Major developments over last 40 years. Portfolio theory. Major developments over last 40 years. Portfolio theory Asset pricing theory.

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The Efficient Markets Hypothesis

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  1. The Efficient Markets Hypothesis Review of Empirical Financial Economics Stephen J. Brown NYU Stern School of Business

  2. Major developments over last 40 years • Portfolio theory

  3. Major developments over last 40 years • Portfolio theory • Asset pricing theory

  4. Major developments over last 40 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis

  5. Major developments over last 40 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance

  6. Major developments over last 40 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance • Derivative Securities, Fixed Income Analysis

  7. Major developments over last 40 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance • Derivative Securities, Fixed Income Analysis • Market Microstructure

  8. Major developments over last 40 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance • Derivative Securities, Fixed Income Analysis • Market Microstructure • Behavioral Finance

  9. The EMH was responsible for the GFC “Neo-liberal policy prescriptions flow from the core theoretical belief in the superiority of unregulated markets - particularly unregulated financial markets. These claims ultimately rest on the "efficient-markets hypothesis", which, in its strongest form, claims that financial-market prices, like stock-market prices, incorporate all available information, and therefore represent the best possible estimate of asset prices. It follows, therefore, that if markets are fully efficient and prices fully informed, there is no reason to believe that asset-price bubbles are probable; and if these do occur, markets will self-correct; and that there is therefore no justification for government intervention to stop them occurring” Kevin Rudd The Monthly 42 (February 2009)

  10. The EMH was responsible for the GFC “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.” Jeremy Grantham (quoted in the New York Times June 5, 2009)

  11. Grantham’s performance over GFC Data from August 07 – May 09 from CRSP Mutual Funds Database

  12. Efficient Markets Hypothesis • No trader’s information gives them an advantage • If information is already incorporated in price Brown, Stephen J. 2011 The Efficient Markets Hypothesis: The demise of the Demon of Chance? Accounting and Finance 51 79-95. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1508702

  13. Examples of EMH applications • Weak form Efficient Markets Hypothesis • Example: trading rule tests • Does active management outperform passive benchmark? • Semi-strong form EMH • Example: Event studies • What information releases are material to investors? • Empirical asset pricing • Example: Orthogonality condition in GMM • Can we explain cross sectional dispersion in required return?

  14. Efficient Markets Hypothesis • Tests of Efficient Markets Hypothesis • Does the market efficiently process information? • What is information? • Estimation of parameters • Does the market efficiently price risk? • What determines the cross section of expected returns?

  15. Efficient Markets Hypothesis

  16. Random Walk Hypothesis

  17. Random Walk Hypothesis “The series looks like a ‘wandering’ one, almost as if once a week the Demon of Chance drew a random number from a symmetrical population of fixed dispersion and added it to the current price to determine the next week’s price” Kendall (1953)

  18. Random Walk Hypothesis • Serial Correlation tests • Variance ratio tests

  19. Random Walk Hypothesis • Serial Correlation tests • Variance ratio tests • Momentum Zero investment portfolio

  20. Random Walk Hypothesis • Well established statistical properties • Strong assumption of stationarity • Time varying conditional expectations not allowed • Neither necessary nor sufficient for EMH

  21. Trading rule tests of EMH • Timmerman (2007) survey • Naïve models using past sample means hard to beat • Recent financial data is most relevant • Short lived episodes of limited predictability • Predictability is not profitability • Necessity: Do not consider all possible patterns of returns • Sufficiency: Cannot profit if all markets rise and fall together

  22. Examining profitability • Appearance of short term profitability .. • at the expense of significant downside risk (Goetzmann et al. 2008) Portfolio Nick Leeson SociétéGénérale Jan 2008 JérômeKerviel Benchmark

  23. An important seminal reference …

  24. Trading Rules: Cowles 1933 • Cowles, A., 1933 Can stock market forecasters forecast? Econometrica 1 309-325 • William Peter Hamilton’s Track Record 1902-1929 • Classify editorials as Sell, Hold or Buy • Novel bootstrap in strategy space Return on DJI

  25. Trading rule predicting sign of excess returnJanuary 1970 - December 2005 Trading rule value S&P500 value Factor-augmented AR logit based on prior 120 month rolling window

  26. Cowles BootstrapJan 1970-Dec 2005

  27. Bottom line: is EMH useful? • For whom is the EMH true? • Uninformed investors with limited capital? • Large well informed and well endowed investors? • Does it have practical implications? • Benchmark comparisons for fund investors? • What information is material to investors? • Useful measures of risk and investment risk premia?

  28. The EMH was not responsible for GFC • Banks invested in beta, thinking it was alpha • They borrowed to invest in market risk • Significant debt exposure at cusp of crisis • Banks failed to predict the collapse of the market • A direct implication of the EMH

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