EMH ( the second paper) Flashcards
(9 cards)
What was Samuelson’s key conclusion about price changes in efficient markets?
If all currently available information is used efficiently, today’s prices already reflect it.
Only new, unpredictable information will affect tomorrow’s prices — meaning price changes must be random.
This is why in efficient markets, properly anticipated prices fluctuate randomly
How did Fama test the efficiency of financial markets?
Fama used empirical methods to test whether stock prices reflect all available information. He studied whether technical or fundamental analysis could beat the market and found no consistent evidence they could — supporting the Efficient Market Hypothesis (EMH).
What did Fama find about small-cap and value stocks?
Fama and French found that small-cap stocks and value stocks tend to outperform. These patterns became part of the Three-Factor Model, possibly due to higher risk — not necessarily inefficiencies — and do not contradict EMH if they are compensation for risk.
What did Fama believe about market anomalies and easy profits?
Fama acknowledged anomalies like the size and value effects but argued that any easy profits would be quickly exploited by investors. This arbitrage would eliminate the opportunity, keeping markets informationally efficient in the long run.
What is the core idea of the variance bounds test in finance?
It tests whether the volatility of stock prices is consistent with the idea that prices equal the expected present value of future dividends.
If markets are efficient and prices are rational forecasts, price volatility should be less than or equal to dividend volatility.
What is the “excess volatility” critique of the Efficient Market Hypothesis (EMH)?
Robert Shiller found that stock prices are more volatile than can be justified by actual future dividends.
This suggests that markets may overreact to news, potentially contradicting the EMH.
However, this could also be explained by dividend smoothing, changing risk preferences, or sampling error.
According to theory, how should stock price volatility compare to dividend volatility?
Prices are forecasts of future dividends, so they should be smoother and less volatile than the actual dividends.
If prices fluctuate more than dividends, it may indicate irrational behavior — or deeper model issues
Does the Efficient Market Hypothesis (EMH) require that prices equal the present value of future dividends?
No. EMH only says that prices reflect all available information.
It doesn’t assume any specific valuation model.
However, EMH is compatible with the dividend discount model if that’s how investors form expectations.
What is the relationship between EMH and valuation models like the dividend discount model?
EMH is a theory of information efficiency; it doesn’t dictate how prices are calculated.
Valuation models like the dividend discount model explain how prices should be formed.
When combined, they form a joint hypothesis — and if empirical tests fail, we can’t know which part is wrong.
