Lecture 1–2: Efficient Markets & Challenges to EMH Flashcards
(11 cards)
What is the Efficient Market Hypothesis (EMH)?
The idea that asset prices fully reflect all available information, meaning consistent excess returns are impossible.
What are the three forms of EMH?
Weak: Prices reflect past price information.
Semi-strong: Prices reflect all public info.
Strong: Prices reflect all info, public and private.
What does EMH imply about stock price movements?
Prices follow a random walk; future movements cannot be predicted from past information.
What are the testable implications of EMH?
No return predictability.
No autocorrelation in returns.
No profitable technical or fundamental trading strategies.
What is the ‘Joint Hypothesis Problem’?
Tests of market efficiency always assume a model of asset pricing, so rejecting EMH may reflect model failure, not market inefficiency.
Name two key challenges to EMH.
Excess volatility.
Predictability of returns.
What is excess volatility (Shiller, 1981)?
Asset prices fluctuate more than justified by changes in fundamentals (e.g., dividends).
What is the Price–Earnings ratio puzzle?
Low P/E ratios predict higher returns, contradicting EMH, which suggests prices should reflect fair value.
What is the Dividend–Price ratio anomaly?
High D/P ratios are followed by higher returns — suggesting return predictability and market inefficiency.
What is momentum in stock returns?
The empirical finding that stocks with high past returns tend to keep performing well in the short term — contradicting EMH.
What is the equity premium puzzle?
Historical equity returns are too high relative to risk-free returns to be explained by standard models — inconsistent with EMH and rational risk aversion.
