Topic 7 - Efficient Market Hypothesis

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Created by
Diana Amielyn

Cards (16)

  • 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