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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets Hypothesis 1
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is efficient if prices “fully reflect” available information and adjust rapidly to new information. 2
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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 known by investors. 3
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. An efficient market is a “fair game” as long as information is equally available. Public info cannot be used to “beat the market.” 4
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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, price levels are not random ; price changes are random (cannot be predicted). 5
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Random Walk Hypothesis of stock prices: Expected price change is positive Price changes about the trend are random 6
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. SecurityPrices Time Random Walk with Positive Trend 7
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why would price changes be random? Prices react to new information Information is new only if it is not expected Flow of information is random Therefore, price changes are random 8
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The law of one price: If prices differences exist, arbitragers will quickly eliminate the difference. 9
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Arbitrage: simultaneously buy and sell at different prices, locking in risk-free profits with no capital outlay. Arbitrage opportunities are uncommon and short-lived in an efficient market. 10
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1. 2. 3. These vary with respect to the set of information 11
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is weak-form efficient if: 12
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market data includes: 13
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of One Price holds if a market is weak-form efficient: arbitrage opportunities are nonexistent or transitory. 14
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Technical Analysis – If the stock market is weak-form efficient, can technical analysis benefit investors? 15
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is semistrong efficient if: 16
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fundamental Analysis – If the stock market is semistrong form efficient, can fundamental analysis benefit investors? 17
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is strong form efficient if: 18
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If the stock market is strong form efficient, do insiders have an advantage over other investors? 19
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are efficient: 20
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are inefficient: 21
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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, but not all, studies conclude that technical analysis is not profitable. 22
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Stock prices exhibit short-run momentum and long-run reversals. Neither tendency is very strong, but both are potentially inconsistent with weak-form efficiency. 23
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information. 24
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 25
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. While most evidence supports semistrong efficiency, several price patterns are inconsistent with semistrong efficiency, however (“anomalies”). An “anomaly” is something that deviates from what is believed to be true. 26
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Small firm/January effect Book-to-Market ratios Post-earnings announcement drift 27
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 28
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 29
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 30
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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk Premiums or market inefficiencies? Anomalies or data mining? 31
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