McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is efficient if prices “fully ______________” available information and adjust rapidly to new information. “Fully reflect” means that set of information cannot be used to benefit investors. Ch 8: The Efficient Market Hypothesis (EMH)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market prices are determined by the actions of buyers and sellers. In an efficient market, security prices fairly reflect all that is ____________________________ Market Efficiency

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. An efficient market is a “fair game” if information is equally available. Public info cannot be used to “beat the market.” “Beat the market:” earn above market (abnormal) returns after deducting transaction _________ and adjusting for ___________ Market Efficiency

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Random: without definite aim, direction, rule or method. If something is random, it cannot be explained or predicted. If a market is efficient, prices are ______ random; price _________ are random. Random Walk and the EMH

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Random Walk Hypothesis of stock prices: Expected price change is ____________________ Positive trend and random about the trend Random Walk and the EMH

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. SecurityPrices Time Random Walk with Positive Trend

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why would price changes be random? Prices react to information Flow of information is _________ Therefore, price changes are random Random Price Changes

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The law of one price states that different prices for the same item cannot persist (unless explained by transaction costs). If prices differences exist, ________________________ will quickly eliminate the difference. Law of One Price

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Arbitrage: simultaneously ________ and __________ at different prices, locking in risk-free profits with no capital outlay. Arbitrage opportunities are uncommon and short-lived in an efficient market. Arbitrage

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Forms of the EMH ________________________ form These vary with respect to the set of information

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Weak Form of EMH A market is weak-form efficient if prices fully reflect all ______________________ data.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Weak Form of EMH Market data includes: past and current ________________ ___________________ ___________________ interest ___________________ transactions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Weak Form of EMH The _________________________ holds if a market is weak-form efficient: arbitrage opportunities are nonexistent or transitory.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Weak Form of EMH _____________________Analysis: using patterns in market information (prices and volume) to predict prices If the stock market is weak-form efficient, can technical analysis benefit investors?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Semistrong Form EMH A market is semistrong efficient if prices fully reflect all ____________________ information

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Semistrong Form EMH Fundamental Analysis - using __________________________ and accounting information to predict prices If the stock market is semistrong form efficient, can fundamental analysis benefit investors?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Strong Form EMH A market is strong form efficient if prices fully reflect ______________ information, public and private.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Strong Form EMH If the stock market is strong form efficient, do insiders have an advantage over other investors?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are efficient: _____________________ broadly (including internationally) Match portfolio risk to your risk tolerance Buy & Hold to minimize ___________ and transaction costs Investment Strategy in Efficient Market

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are inefficient, you can try to beat the market by identifying ___________________ sectors or securities and overweighting (fundamental analysis) or by using technical analysis. Inefficient Market Investment Strategy

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The evidence is generally consistent with weak form efficiency in securities markets. Most studies conclude that technical analysis is not profitable. Not all evidence is consistent with weak form efficiency, however. Tests of Weak Form Efficiency

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tests of Weak Form (Cont.) Stock prices exhibit short-run _________________ and long-run ______________________. Neither tendency is very strong, but both are potentially inconsistent with weak-from efficiency.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tests of Semistrong Efficiency The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information. Several price patterns are inconsistent with semistrong efficiency, however (“_______________________”).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. An “anomaly” is something that deviates from what is believed to be true. Tests of Semi-strong Form: Anomalies

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. ______________ Firm / January Effect Neglected Firm Market to _______________ Ratios Post-Earnings Announcement Drift Tests of Semi-strong Form: Anomalies

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Implications of Test Results Risk Premiums or market inefficiencies? Anomalies or data mining? Behavioral Interpretations: inefficiencies might be the result of investors’ irrationality in systematic ways.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Fund and Professional Manager Performance Some evidence of persistent positive and negative performance Superstar phenomenon: financial markets might be efficient for most, but not all participants.