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Chapter 12. The Efficient Market Hypothesis. Random Walk and the EMH. Random Walk - stock prices are random Actually submartingale Expected price is positive over time Positive trend and random about the trend. Random Walk with Positive Trend. Security Prices. Time.

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Chapter 12

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Chapter 12

Chapter 12

The Efficient Market Hypothesis

Random walk and the emh

Random Walk and the EMH

  • Random Walk - stock prices are random

    • Actually submartingale

      • Expected price is positive over time

      • Positive trend and random about the trend

Chapter 12

Random Walk with Positive Trend




Random price changes

Random Price Changes

  • Why are price changes random?

    • Prices react to information

    • Flow of information is random

    • Therefore, price changes are random

Emh and competition

EMH and Competition

  • Stock prices fully and accurately reflect publicly available information

  • Once information becomes available, market participants analyze it

  • Competition assures prices reflect information

Forms of the emh

Forms of the EMH

  • Weak

  • Semi-strong

  • Strong

Types of stock analysis

Types of Stock Analysis

  • Technical Analysis - using prices and volume information to predict future prices

    • Weak form efficiency & technical analysis

  • Fundamental Analysis - using economic and accounting information to predict stock prices

    • Semi strong form efficiency & fundamental analysis

Implications of efficiency for active or passive management

Implications of Efficiency for Active or Passive Management

  • Active Management

    • Security analysis

    • Timing

  • Passive Management

    • Buy and Hold

    • Index Funds

Market efficiency and portfolio management

Market Efficiency and Portfolio Management

Even if the market is efficient a role exists for portfolio management

  • Appropriate risk level

  • Tax considerations

  • Other considerations

Tests of semi strong form anomalies

Tests of Semi-strong Form: Anomalies

  • Small Firm Effect (January Effect)

  • Neglected Firm

  • Market to Book Ratios

  • Post-Earnings Announcement Drift

Implications of test results

Implications of Test Results

  • Risk Premiums or market inefficiencies

  • Anomalies or data mining

  • Behavioral Interpretation

    • Inefficiencies exist

    • Caused by human behavior

Behavioral possibilities

Behavioral Possibilities

  • Forecasting Errors

  • Overconfidence

  • Regret avoidance

  • Framing and mental accounting errors

Chapter 12

When the market risk premium declines, stock prices will ________.A) riseB) fallC) recoverD) have excess volatilityAnswer B

Chapter 12

According to the efficient market hypothesis, __________.A) positive alphas on stocks will disappear quicklyB) low beta stocks are consistently underpricedC) high beta stocks are consistently overpricedD) None of the above answers is correctAnswer A

Chapter 12

Research on the strong form of market efficiency shows that ________ are generally able to achieve superior returns.A) members of the SECB) the majority of professional mutual fund managersC) corporate insidersD) stock brokersAnswer C

Chapter 12

The ______________ of the efficient market hypothesis suggests that there is little or nothing to be gained from studying past stock price trends.A) weak formB) semi-weak formC) semi-strong formD) strong form Answer A

Chapter 12

Which one of the following forms of market efficiency is violated if you can earn excess return by buying stocks of firms which make merger announcements?A) Weak form.B) Semi-weak form.C) Semi-strong form.D) Strong form.Answer C

Chapter 12

The efficient market hypothesis suggests that ___________.A) no investors can earn a positive return at any point in time.B) no investors can earn a positive return persistently over time.C) no investors can earn an excess return at any point in time.D) no investors can earn an excess return persistently over timeAnswer D

Chapter 12

The January effect of small firms is greatest ________.A) in leap yearsB) in presidential election yearsC) late in the monthD) early in the monthAnswer D

Chapter 12

Which of the following has(have) been considered market anomalies?A) the reversal effectB) the book-to-market effectC) the small-firm January effectD) All of the above have been considered market anomalies Answer D

Chapter 12

Empirical evidence supporting the semi-strong form market efficiency suggests that investors should follow ____________ investment strategy.A) a passiveB) an activeC) a conservativeD) an aggressiveAnswer A

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