1. Empirical Financial Economics The Efficient Markets Hypothesis Review of Empirical Financial Economics Stephen Brown NYU Stern School of Business UNSW PhD Seminar, June 19-21 2006

2. Major developments over last 35 years  Portfolio theory

3. Major developments over last 35 years  Portfolio theory  Asset pricing theory

4. Major developments over last 35 years  Portfolio theory  Asset pricing theory  Efficient Markets Hypothesis

5. Major developments over last 35 years  Portfolio theory  Asset pricing theory  Efficient Markets Hypothesis  Corporate finance

6. Major developments over last 35 years  Portfolio theory  Asset pricing theory  Efficient Markets Hypothesis  Corporate finance  Derivative Securities, Fixed Income Analysis

7. Major developments over last 35 years  Portfolio theory  Asset pricing theory  Efficient Markets Hypothesis  Corporate finance  Derivative Securities, Fixed Income Analysis  Market Microstructure

8. Major developments over last 35 years  Portfolio theory  Asset pricing theory  Efficient Markets Hypothesis  Corporate finance  Derivative Securities, Fixed Income Analysis  Market Microstructure  Behavioral Finance

9. Efficient Markets Hypothesis which implies the testable hypothesis... where is part of the agent’s information set In returns: wher e

10. Examples  Random walk model  Assumes information set is constant  Event studies  For event dummy (event)  Time variant risk premia models  z t includes X  Important role of conditioning information

11. Efficient Markets Hypothesis  Tests of Efficient Markets Hypothesis  What is information?  Does the market efficiently process information?  Estimation of parameters  What determines the cross section of expected returns?  Does the market efficiently price risk?

12. Efficient Markets Hypothesis  Weak form tests of Efficient Markets Hypothesis  Example: trading rule tests  Semi-strong form tests of EMH  Example: Event studies  Strong form tests of EMH  Example: Insider trading studies (careful about conditioning!)

13. Trading Rules: Cowles 1933  Cowles, A., 1933 Can stock market forecasters forecast? Econometrica 1 309- 325  William Peter Hamilton’s Track Record 1902-1929  Classify editorials as Sell, Hold or Buy  Novel bootstrap in strategy space Return on DJI

15. Asset pricing models: GMM paradigm  Match moment conditions with sample moments  Test model by examining extent to which data matches moments  Estimate parameters

16. Example: Time varying risk premia Time varying risk premia imply a predictable component of excess returns where the asset pricing model imposes constraint

17. Estimating asset pricing models: GMM  Define residuals  Residuals should not be predictable using instruments z t-1 that include the predetermined variables X t-1  Choose parameters to minimize residual predictability

18. Estimating asset pricing models: Maximum likelihood  Define residuals  Choose parameters to minimize  Establishes a connection to Fama and MacBeth  Resolves the “measurement error problem”  Relationship to GMM: when instruments z t include the predetermined variables X t

19. Fama and MacBeth procedure 05 10152025 30 t

20. Fama and MacBeth procedure 05 10152025 30 t

21. Fama and MacBeth procedure 05 10152025 30 t

22. The Likelihood Function

23. The market model regression

24. The Fama MacBeth cross section regression

25. Updating market model

26. Full Information Maximum Likelihood

27. Estimating asset pricing models: A simpler way  Time varying risks and time varying premia:  This collapses to a simpler model  which generalizes:  Investment management style analysis (GSC)  Performance benchmark issues  “Pure play” definitions

28. Conclusion  Efficient Market Hypothesis is alive and well  EMH central to recent developments in empirical Finance  EMH highlights importance of appropriate conditioning  in empirical financial research  in practical applications