# Efficient Market Hypothesis

**Topics:**Stock market, Financial markets, Efficient-market hypothesis

**Pages:**7 (1509 words)

**Published:**March 3, 2011

Efficient Market Hypothesis

Road Map

Part A Introduction to Finance.

Part B Valuation of assets, given discount rates.

Part C Determination of discount rates.

Part D Introduction to corporate finance.

• Efficient Market Hypothesis (EMH).

• Capital investment decisions (capital budgeting).

• Financing decisions.

Main Issues

• Efficient Market Hypothesis (EMH)

• Empirical evidence on EMH

• Implications of EMH

• Questions and practical issues about EMH

13-2 Efficient Market Hypothesis Chapter 13

Contents

1 EfficientMarket Hypothesis (EMH) . . . . . . . . . . . . . . 13-3 2 Empirical Tests of EMH . . . . . . . . . . . . . . . . . . . . 13-6 2.1 Supportive Evidence of EMH . . . . . . . . . . . . . . . . . . . . 13-7 2.2 Negative Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 13-12 3 Implications of EMH . . . . . . . . . . . . . . . . . . . . . . 13-14 4 Questions about EMH . . . . . . . . . . . . . . . . . . . . . 13-15 5 Practical Issues about EMH . . . . . . . . . . . . . . . . . . 13-16 6 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-17 15.407 Lecture Notes Fall 2003 _c Jiang Wang

Chapter 13 Efficient Market Hypothesis 13-3

1 Efficient Market Hypothesis (EMH)

In an efficient financial market, an asset’s price should be the best possible estimate of its economic values.

Definition: A financial market is (informationally) efficient when market prices reflect all available information about value. A precise definition needs to answer two questions:

1. What is “all available information”?

2. What does it mean to “reflect all available information”? Different answers to these questions give rise to different versions of market efficiency.

_c Jiang Wang Fall 2003 15.407 Lecture Notes

13-4 Efficient Market Hypothesis Chapter 13

Intuitive answers to these two questions:

1. All available information includes:

(a) Past prices – Weak form.

(b) All public information – Semi-Strong Form.

- past prices, news, etc.

(c) All information including inside information – Strong Form. 2. “Prices reflect all available information” means that financial transactions at market prices, using the available information, are zero NPV activities.

Question: Why should prices reflect available information?

Answer: If not, there would be arbitrage opportunities.

15.407 Lecture Notes Fall 2003 _c Jiang Wang

Chapter 13 Efficient Market Hypothesis 13-5

Example. Suppose that Merck announces a new allergy drug

that could completely prevent hay-fever. How should the share price of Merck react to this news?

Consider three hypothetical paths for price adjustments:

1. Increase immediately to a new equilibrium level

2. Increase gradually to the new equilibrium level

3. First over-shoot and then settle back to new equilibrium level. Efficient market

reaction

Over-reaction

Under-reaction

-10 -8 -6 -4 -2 0 2 4 6 8 10

Day relative to announcement

Price What do you think?

_c Jiang Wang Fall 2003 15.407 Lecture Notes

13-6 Efficient Market Hypothesis Chapter 13

2 Empirical Tests of EMH

The tests of EMH often start with the following equation:

˜r1 = ¯r +˜u1

where

• ¯r is the risk-adjusted expected return from a pricing model (e.g. CAPM and APT) and

• ˜u1 is the residual term.

EMH says that the residual term ˜u1 must be:

1. zero on average

2. unpredictable based on current information (at time 0).

Under EMH of above forms, asset returns are unpredictable.

Example. IID returns.

15.407 Lecture Notes Fall 2003 _c Jiang Wang

Chapter 13 Efficient Market Hypothesis 13-7

2.1 Supportive Evidence of EMH

1. Weak form of EMH is supported by the data.

_ Technical trading rules are not consistently profitable.

S&P 500 Index (1980-1984) versus Coin-tossing

Source: R. Brealey and S. Myers, Principles of Corporate Finance. _c Jiang Wang Fall 2003 15.407 Lecture Notes

13-8 Efficient Market Hypothesis Chapter 13

_ Serial correlation in daily stock returns is close to zero. Serial...

Please join StudyMode to read the full document