Efficient Market Hypothesis Flashcards
Rate of return formula
R = Pt+₁ - Pt + C / Pt
(capital gains Pt+1 - Pt) add any cash payments
Efficient market hypothesis
Use all available information for expectations, so expectations are the same as the optimal forecast!
What does this imply
Pe t+1 = Pof t+1 so Re = Rof
Expected price = optimal forecast price
And
Expected rate of return = Optimal forecast rate of return
If we assume the market is in equilibrium, what happens to rate of return.
Re = R*
then as Re=Rof the efficient market hypothesis equation:
Rof = R*
Key: optimal forecast return (using all info) = equilibrium return§
Rational behind the hypothesis
(if Rof>R*, or <)
Key finding:
If Rof > R* , Pt increases (since demand rises) , so Rof falls back down (using rate of return equation Pt up)
If Rof < R*, Pt falls (demand falls since lower than equilibrium return), so Rof increases
in both situations they balance out to Rof=R*
Meaning all unexploited profit opportunities will be removed.
Different definitions of EMH (3)
Weak - prices reflect past prices
Semi-strong - prices reflect past prices, AND publicly available info.
Strong - prices reflect both those and all private information that can be possibly acquired
Implications of market efficiency for each definition
E.g if markets are efficient in weak sense…
Weak efficient markets - prices follow random walk, technical analysis is not useful
Semi-strong efficient markets - prices adjust immediately to announcements, no profits from fundamental analysis
Strong efficient markets - impossible to beat market apart from luck
Is evidence in favour of weak form of market in efficiency
Start with reasons for yes (2)
Yes
- some evidence technical analysis is not useful
- prices & exchange rates follow a random walk, no systematic patterns
No - unfavourable evidence on weak form EMH (6)
Small firm effect
Calendar patterns
Market overeaction
Excessive volatility
Mean reversion
New info relay
Small firm effect - against weak form EMH
Studies show small firms earning abnormally high returns over long periods of time
(so not random, its systematic pattern!)
Calendar patterns - 2 effects
Monday effect - returns on mondays are lower than on other days of the week
January effect - returns in January much higher than other months
(so systematic pattern! not random!)
Market overreaction
Evidence stock prices may overeact to announcements and so pricing errors are corrected slowly.
(So not just determined by past prices!)
Excessive volatility
Fluctuations in prices may be much greater than is warranted by fluctuations in their fundamental value…
(so prices arent just determined by past prices!)
Mean reversion
Stocks with low returns today tend to have high returns in future and vice versa,
(SO SYSTEMIC PATTERNNOT RANDOM)
New info delay
new info is not always immediately incorporated into stock prices
