Fin 352 professor dow
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How to test for market efficiency. PowerPoint PPT Presentation


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FIN 352 – Professor Dow. How to test for market efficiency. How to test?. Fama : Test the efficient market hypothesis using different information sets. Three categories : Weak Semi-Strong Strong Some tests directly use this categorization, others do not. Weak form efficiency.

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Fin 352 professor dow

FIN 352 – Professor Dow

How to test for market efficiency.


How to test

How to test?

  • Fama: Test the efficient market hypothesis using different information sets.

  • Three categories:

    • Weak

    • Semi-Strong

    • Strong

  • Some tests directly use this categorization, others do not.


Weak form efficiency

Weak form efficiency

  • All past-price information is fully reflected in stock prices.

  • Can’t use past prices to forecast future prices.

  • If true, technical analysis is not useful.


Semi strong efficiency

Semi-Strong Efficiency

  • All public information is fully reflected in stock prices.

  • If true, fundamental analysis is not useful.


Strong form efficiency

Strong Form Efficiency

  • All information is reflected in stock prices.

  • Implies that trading on insider information shouldn’t be profitable.

  • Not true

  • But not legal


Examples of tests

Examples of tests

  • A) Patterns in stock prices.

  • B) Back-testing trading rules.

  • C) Do categories of stocks earn abnormal returns?

  • D) Event studies.

  • E) Do stock prices move “too much?”

  • F) Bubbles.

  • G) Do some investors outperform the market?


A patterns in stock prices

A) Patterns in Stock Prices

  • Serial Correlation > 0, Momentum

  • Serial Correlation < 0, Mean Reversion

  • Serial Correlation = 0, Random Walk

  • Weak Form EMH predicts random walk


B backtesting trading rules

B) Backtesting Trading Rules

  • See if trading rules are profitable when applied to historical stock price data.

  • Data Mining

  • In-Sample vs. Out-of-Sample


C do some types of stocks earn abnormal returns

C) Do some types of stocks earn abnormal returns

  • Value stocks

  • Small stocks

  • Or is it microcap/neglected stocks?

  • Is it is risk premium?


D event studies

D) Event Studies

  • Abnormal returns: Stocks earn greater returns than they “should”: Ri – E(R)

  • Theory implies that stocks should earn abnormal returns when news first comes out, but not afterwards (stock prices are quick to adjust to news)

  • Book gives example where they use excess returns (Ri-Rm) to measure response to event. Response is slower than it should be.


E bubbles

E) Bubbles

  • Increases in asset prices not justified by “fundamentals”

  • At some point, bubbles pop!

  • Shouldn’t have bubbles if markets are efficient.

  • Recent experience with real estate and stock price bubbles.


F do stock prices move too much

F) Do stock prices move “too much”

  • Theory: Stock price is the present value of expected future dividend payments.

  • Stock prices shouldn’t vary more than dividends or earnings do.

  • But there is more variation

  • Similar idea to bubbles: stock prices move based on psychological reasons rather than fundamental reasons.


G do some investors outperform others

G) Do some investors outperform others?

  • Why do some investors do well?

    • Luck

    • Higher risk

    • Skill

  • Mutual funds tests


What do we know

What do we know

  • Markets are broadly efficient, but some important exceptions.

  • Bubbles

  • Some people understand the economy better – but do you?


Implications for investing

Implications for investing

  • Build around index funds: Well-diversified and low cost

  • Do bubbles imply market timing?

  • Do you want to engage in fundamental analysis?


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