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Chapter 4 Financial 2

The document discusses the efficient market hypothesis and its three forms: weak, semi-strong, and strong. It introduces the concept that stock prices fully reflect all available public information. The three forms differ in the types of information assumed to be reflected in current stock prices. The document also discusses tests that have been done to evaluate the different forms of market efficiency.

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20 views3 pages

Chapter 4 Financial 2

The document discusses the efficient market hypothesis and its three forms: weak, semi-strong, and strong. It introduces the concept that stock prices fully reflect all available public information. The three forms differ in the types of information assumed to be reflected in current stock prices. The document also discusses tests that have been done to evaluate the different forms of market efficiency.

Uploaded by

Adrian Muñoz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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FINANCIAL MANAGEMENT II

CHAPTER 4: EFFICIENT CAPITAL MARKETS

4.1 Introduction
4.2 Three forms of EMH
4.3 Test of the three forms of market efficiency.

4.1 Introduction:
Early applications of computers in economics in the 1950s:
• Analyse economic time series.
• Study evolution of economic variables over time.
• Predict boom & bust periods.

Maurice Kendall: Presented a controversial paper to the Royal Statistical Society on


the behaviour of stock and commodity prices.
The stock price will immediately reflect the “good news” implicit in the model ́s
forecast.
- Overvalued —> Sell —> Price falls —> Equilibrium.
- Undervalued —> Buy —> Price rises —> Equilibrium.

Any information that could be used to predict stock performance should already be re-
flected in stock prices.

Prices increase or decrease only in response to new information.


“New information”= unpredictable

Stock prices that change in response to new (unpredictable) information also must move
unpredictably.

Random Walk Theory: The movement of stock prices from day to day DO NOT reflect
any pattern. Statiscally speaking, the movement of stock prices is random.

Efficient Capital Markets


• A market is efficient if prices "fully reflect" available information and adjust rapidly
to new information.
• In an efficient market, public information cannot be used to earn above market returns
after adjusting for risk.
• Efficient market DO NOT imply that investors cannot earn a positive return in the
stock market.
• They do mean that, on average, you will earn a return that is appropriate for the risk
undertaken
• There is not a bias in prices that can be exploited to earn excess returns.

What is the Efficient Market Hypothesis (EMH)?


• Securities are normally in equilibrium and are "fairly prices".
• Investors cannot "beat the market" expect through good luck or better information.
4.2 Three forms of EMH:

1. Weak form:
• Postulates that current prices fully reflect all information in PAST prices.
• Technical Analysis: using patterns in market data to predict price changes.
• If the stock market is weak form efficient, can technical analysis benefit investors? NO

2. Semi - Strong Form:


• Postulates that current prices fully reflect all past prices and ALL PUBLICLY avail-
able information.
• Fundamental analysis: using economic and accounting information to evaluate a secu-
rity.
• If the stock market is semi-strong form efficient, can fundamental analysis benefit in-
vestors? NO.

3. Strong Form:
• Postulates that current prices fully reflect all information, public and private.
• If the stock market is strong form efficient, do insiders have an advantage over other
investors? NO.
i.e., knowing a merger is going to take place before it is announced publicly will not
produce profits.
• Although illegal, evidence that prices move before public announcements, suggesting
insider information.
• Insider trading appears profitable, indicating markets are NOT strong form efficient.

- Fundamental Analyst:
- Research the value of stocks by delving into detailed accounting and operating
numbers.
- These analysts DO NOT believe in semi-strong form of market efficiency.

- Technical Analyst:
- Forecast stock prices based on the watching the fluctuations in historical prices.
- These analysts DO NOT believe any form of market efficiency.

4.3 Test of the three forms of market efficiency:

Weak form of EMH:


Researchers measured the profitability of some of the trading rules used by those in-
vestors who claim to find patterns in security prices.

Semi-strong form of EMH:


Researchers measured how rapidly security prices respond to different items of news,
such as earnings or dividend announcements, news of a takeover, or macroeconomic in-
formation.

Strong form of EMH:


Researchers have examined the recommendations of professional security analysts and
have looked for mutual funds or pension funds that could predictably outperform the
market.

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