Topic 7 - Efficient Market Hypothesis

• Rate of return

  The sum of the capital gains (P_t+1 - P_t) plus any cash payments (C)
• Expected rate of return

  R = P_ t+1 - P_ t + C / P_t
• Efficient Market Hypothesis

  The expectations are equal to optimal forecasts using all available information
• In an efficient market, all unexploited profit opportunities will be eliminated
• Different definitions of EMH

  • Weak form: prices reflect information contained in past prices
  • Semi-strong form: prices reflect all publicly available information
  • Strong form: prices reflect all publicly available and private information
• Weak form EMH

  • Asset prices follow a random walk and technical analysis is not useful
• Semi-strong form EMH

  • Prices adjust immediately to any announcement
  • No profits should be made by studying company fundamentals
• Strong form EMH

  • No fund manager can ever beat the market - other than by luck
• Testing the weak-form EMH

  1. Show price changes are independent over time

  2. Show investors using chart analysis do not outperform the market
• Testing the semi-strong form EMH

  1. Check if stock prices jump following news

  2. Show investors using fundamental analysis do not outperform the market
• Testing the strong-form EMH


  1. Check if any fund manager is able to beat the market long-term

  2. Check if any sustained outperformance is a sign of fraud
• There is some evidence that trading rules based on purely technical analysis do not outperform the market
• Stock prices and exchange rates follow a random walk
• Unfavourable evidence on EMH

  • Small-firm effect
  • Calendar patterns (Monday effect, January effect)
  • Market overreaction
  • Excessive volatility
  • Mean reversion
  • New information delay
• Abnormal return

  The difference between the actual return and the expected return (r_ a = r_i - E[r_i])
• Earnings announcement drift: companies that announce higher than expected earnings provide also positive abnormal returns in the days following the announcement