Efficient Market Hypothesis

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Chapter 13
Efficient Market Hypothesis
Road Map
Part A Introduction to Finance.
Part B Valuation of assets, given discount rates.
Part C Determination of discount rates.
Part D Introduction to corporate finance.
• Efficient Market Hypothesis (EMH).
• Capital investment decisions (capital budgeting).
• Financing decisions.
Main Issues
• Efficient Market Hypothesis (EMH)
• Empirical evidence on EMH
• Implications of EMH
• Questions and practical issues about EMH
13-2 Efficient Market Hypothesis Chapter 13
Contents
1 EfficientMarket Hypothesis (EMH) . . . . . . . . . . . . . . 13-3 2 Empirical Tests of EMH . . . . . . . . . . . . . . . . . . . . 13-6 2.1 Supportive Evidence of EMH . . . . . . . . . . . . . . . . . . . . 13-7 2.2 Negative Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 13-12 3 Implications of EMH . . . . . . . . . . . . . . . . . . . . . . 13-14 4 Questions about EMH . . . . . . . . . . . . . . . . . . . . . 13-15 5 Practical Issues about EMH . . . . . . . . . . . . . . . . . . 13-16 6 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-17 15.407 Lecture Notes Fall 2003 _c Jiang Wang

Chapter 13 Efficient Market Hypothesis 13-3
1 Efficient Market Hypothesis (EMH)
In an efficient financial market, an asset’s price should be the best possible estimate of its economic values.
Definition: A financial market is (informationally) efficient when market prices reflect all available information about value. A precise definition needs to answer two questions:
1. What is “all available information”?
2. What does it mean to “reflect all available information”? Different answers to these questions give rise to different versions of market efficiency.
_c Jiang Wang Fall 2003 15.407 Lecture Notes
13-4 Efficient Market Hypothesis Chapter 13
Intuitive answers to these two questions:
1. All available information includes:
(a) Past prices – Weak form.
(b) All public information – Semi-Strong Form.
- past prices, news, etc.
(c) All information including inside information – Strong Form. 2. “Prices reflect all available information” means that financial transactions at market prices, using the available information, are zero NPV activities.

Question: Why should prices reflect available information?
Answer: If not, there would be arbitrage opportunities.
15.407 Lecture Notes Fall 2003 _c Jiang Wang
Chapter 13 Efficient Market Hypothesis 13-5
Example. Suppose that Merck announces a new allergy drug
that could completely prevent hay-fever. How should the share price of Merck react to this news?
Consider three hypothetical paths for price adjustments:
1. Increase immediately to a new equilibrium level
2. Increase gradually to the new equilibrium level
3. First over-shoot and then settle back to new equilibrium level. Efficient market
reaction
Over-reaction
Under-reaction
-10 -8 -6 -4 -2 0 2 4 6 8 10
Day relative to announcement
Price What do you think?
_c Jiang Wang Fall 2003 15.407 Lecture Notes
13-6 Efficient Market Hypothesis Chapter 13
2 Empirical Tests of EMH
The tests of EMH often start with the following equation:
˜r1 = ¯r +˜u1
where
• ¯r is the risk-adjusted expected return from a pricing model (e.g. CAPM and APT) and
• ˜u1 is the residual term.
EMH says that the residual term ˜u1 must be:
1. zero on average
2. unpredictable based on current information (at time 0).
Under EMH of above forms, asset returns are unpredictable.
Example. IID returns.
15.407 Lecture Notes Fall 2003 _c Jiang Wang
Chapter 13 Efficient Market Hypothesis 13-7
2.1 Supportive Evidence of EMH
1. Weak form of EMH is supported by the data.
_ Technical trading rules are not consistently profitable.
S&P 500 Index (1980-1984) versus Coin-tossing
Source: R. Brealey and S. Myers, Principles of Corporate Finance. _c Jiang Wang Fall 2003 15.407 Lecture Notes
13-8 Efficient Market Hypothesis Chapter 13
_ Serial correlation in daily stock returns is close to zero. Serial...
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