Efficient Market Hypothesis (EMH)

Do security prices reflect information ?

Why look at market efficiency?
Implications for business and corporate
finance
Market Efficiency and Implications for investment
Behavioral Finance

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Random Walk and the EMH Random Walk with Positive Trend

Random Walk - stock prices are random Security

Actually submartingale Prices
Expected price is positive over time
Positive trend and random about the trend

Time
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Random Price Changes EMH and Competition

Why are price changes random? Stock prices fully and accurately reflect
Prices react to information publicly available information.
Flow of information is random Once information becomes available,
Therefore, price changes are random market participants analyze it.
Competition assures prices reflect
information.

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 Forms of the EMH Types of Stock Analysis

Technical Analysis - using prices and volume

Weak
information to predict future prices.
Semi-strong Weak form efficiency & technical analysis
Strong Fundamental Analysis - using economic and
accounting information to predict stock prices.
Semi strong form efficiency & fundamental
analysis

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Active or Passive Management Market Efficiency & Portfolio Management

Active Management Even if the market is efficient a role

Security analysis exists for portfolio management:
Timing Appropriate risk level
Passive Management Tax considerations
Buy and Hold Other considerations
Index Funds

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Empirical Tests of Market Efficiency How Tests Are Structured

Event studies 1. Examine prices and returns over time

Assessing performance of professional
managers
Testing some trading rule

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 Returns Over Time How Tests Are Structured (cont’d)

2. Returns are adjusted to determine if they

are abnormal.
Market Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
-t 0 +t et = Actual - (at + btRmt)

Announcement Date

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How Tests Are Structured (cont’d) Issues in Examining the Results

2. Returns are adjusted to determine if Magnitude Issue

they are abnormal. Selection Bias Issue
Market Model approach Lucky Event Issue
c. Cumulate the excess returns over time:
Possible Model Misspecification

-t 0 +t
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What Does the Evidence Show? Anomalies

Technical Analysis Small Firm Effect (January Effect)

Short horizon Neglected Firm
Long horizon Market to Book Ratios
Fundamental Analysis Reversals
Post-Earnings Announcement Drift
Anomalies Exist

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 Explanations of Anomalies Information Processing

May be risk premiums Forecasting Errors

Behavioral Explanations Overconfidence
Information Processing Errors Conservatism
Behavioral Biases Sample Neglect and
Limits to Arbitrage Representativeness

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Behavioral Biases Limits to Arbitrage

Framing Fundamental Risk

Mental Accounting Implementation Costs
Regret Avoidance Model Risk

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Mutual Fund Performance

Some evidence of persistent positive

and negative performance.
Potential measurement error for
benchmark returns.
Style changes
May be risk premiums
Superstar phenomenon

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