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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets Hypothesis 1.

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Presentation on theme: "McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets Hypothesis 1."— Presentation transcript:

1 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets Hypothesis 1

2 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

3 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

4 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

5 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

6 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

7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. SecurityPrices Time Random Walk with Positive Trend 7

8 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

9 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

10 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

11 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

12 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is weak-form efficient if: 12

13 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Market data includes: 13

14 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

15 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

16 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is semistrong efficient if: 16

17 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

18 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is strong form efficient if: 18

19 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

20 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are efficient: 20

21 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are inefficient: 21

22 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

23 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

24 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

25 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 25

26 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

27 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

28 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 28

29 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 29

30 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 30

31 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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