Module 3 Module 3

Reading Material 1 Reading Material 2

Rationale Behind the Hypothesis Evidence in favor of the market hypothesis.

 concept of arbitrage - which market
participants (arbitrageurs) eliminate EVIDENCE IN FAVOR OF MARKET EFFICIENCY
unexploited profit opportunities, meaning  examined the performance of investment analysts
returns on a security that are larger than what and mutual funds, whether stock prices reflect
is justified by the characteristics of that publicly available information, the random-walk
security. behavior of stock prices, and the success of so-
called technical analysis.
I. pure arbitrage - the elimination of unexploited profit PERFORMANCE OF INVESTMENT ANALYSTS AND
opportunities involves no risk, MUTUAL FUNDS
 One common test that has been performed is to
II. Risk arbitrage - the arbitrageur takes on some risk take buy and sell recommendations from a group
when eliminating the unexploited profit of advisers or mutual funds and compare the
opportunities performance of the resulting selection of stocks
with the market as a whole.
Stronger Version of the Efficient Market MUTUAL FUNDS ARE ALSO NOT FOUND TO BEAT
Hypothesis THE MARKET
 not only do not outperform the market on average,
but when they are separated into groups
 an efficient market as one in which according to whether they had the highest or
expectations are optimal forecasts using all lowest profits in a chosen period,
available information, but they also add the
condition that an efficient market is one in
which prices reflect the true fundamental The conclusion from the study of investment advisers
(intrinsic) value of the securities and mutual fund performance is this: Having performed
well in the past does not indicate that an investment
 In an efficient market, all prices are always adviser or a mutual fund will perform well in the future.It
correct and reflect market fundamentals (items says that some advisers will be lucky and some will be
that have a direct impact on future income unlucky.
streams of the securities). The conclusion from the study of investment advisers
and mutual fund performance is this: Having performed
Important implications of a strong view of market well in the past does not indicate that an investment
efficiency. adviser or a mutual fund will perform well in the future.It
says that some advisers will be lucky and some will be
unlucky.
 it implies that in an efficient capital market, one
investment is as good as any other because Do Stock Prices Reflect Publicly Available
the securities' prices are correct. Information?
The efficient market hypothesis predicts that stock
 it implies that a security's price reflects all prices will reflect all publicly available information.if
available information about the intrinsic value information is already publicly available, a positive
of the security announcement about a company will not, on average,
raise the price of its stock because this information is
 it implies that security prices can be used by
already reflected in the stock price.
managers of both financial and nonfinancial
firms to assess their cost of capital (cost of
financing their investments) accurately and
hence that security prices can be used to help
them make the correct decisions about
whether a specific investment is worth making
or not.
Random-Walk Behavior of Stock Prices Module 3
 describes the movements of a variable Reading Material 3
whose future changes cannot be predicted
(are random) because, given today's value, Small Firm Effect
the variable is just as likely to fall as to rise.  small firms have earned abnormally high returns
over long periods of time, even when the greater
 An important implication of the efficient risk for these firms has been taken into account.
market hypothesis is that stock prices should
approximately follow a random walk; that is,  The small-firm effect seems to have diminished in
future changes in stock prices should, for all recent years, but it is still a challenge to the theory
practical purposes, be unpredictable. of efficient markets.

 most commonly mentioned in the press January Effect

because it is the most readily  Over long periods of time, stock prices have
comprehensible to the public tended to experience an abnormal price rise from
December to January that is predictable and
 hence inconsistent with random-walk behavior.
two types of tests to explore the hypothesis that
stock prices follow a random walk.  Some financial economists argue that the January
 they examine stock market records to see if effect is due to tax issues. Investors have an
changes in stock prices are systematically incentive to sell stocks before the end of the year
related to past changes and hence could in December because they can then take capital
have been predicted on that basis. losses on their tax return and reduce their tax
 examines the data to see if publicly available liability.
information other than past stock prices could
have been used to predict changes.
Market Overreaction
 Recent research suggests that stock prices may
Technical analysis overreact to news announcements and that the
 A popular technique used to predict stock pricing errors are corrected only slowly.
prices, it aims to study past stock price data
and search for patterns such as trends and  When corporations announce a major change in
regular cycles. earnings, say, a large decline, the stock price may
overshoot, and after an initial large decline, it may
The first performs the empirical analysis described rise back to more normal levels over a period of
earlier to evaluate the performance of any financial several weeks.
analyst, technical or otherwise.
Excessive Volatility
The second type of test takes the rules developed in  A closely related phenomenon to market
technical analysis for when to buy and sell stocks overreaction is that the stock market appears to
and applies them to new data display excessive volatility; that is, fluctuations in
stock prices may be much greater than is
warranted by fluctuations in their fundamental
value.

Mean Reversion
 Stocks with low returns today tend to have high
returns in the future, and vice versa.

 indicates that there will be a predictable positive

change in the future price, suggesting that stock
prices are not a random walk.