The Efficient Market Hypothesis

1

• The Efficient Market Hypothesis

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Efficient Market Hypothesis (EMH)

• Do security prices reflect information ?
• Why look at market efficiency
• Implications for business and corporate finance
• Implications for investment

3
Forms of the EMH

• Weak
• Semi-strong
• Strong

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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

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Random Walk Hypothesis

• Why are price changes random?
• Prices react to information
• Flow of information is random
• Therefore, price changes are random

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Random Walk with Positive Trend
Security Prices
Time
Irwin/McGraw-Hill
9-4

• The McGraw-Hill Companies, Inc., 1998

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Empirical Tests of Market Efficiency

• Event studies
• Assessing performance of professional managers
• Testing some trading rule

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Returns Over Time
0
t
-t
Announcement Date
Irwin/McGraw-Hill

• The McGraw-Hill Companies, Inc., 1998

9-13
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What Does the Evidence Show?

• Technical Analysis
• Fundamental Analysis
• Anomalies Exist

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Anomalies

• Small Firm Effect (January Effect)
• Neglected Firm
• Market to Book Ratios
• Reversals
• Value Line Enigma
• Post-Earnings Announcement Drift
• Higher Level Correlation in Security Prices

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Mutual Fund and Professional Manager Performance

• Some evidence of persistent positive and negative
  performance
• Potential measurement error for benchmark returns
• Style changes
• May be risk premiums
• Superstar phenomenon

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Implications of Efficiency for Active or Passive
Management

• Active Management
• Security analysis
• Timing
• Passive Management
• Buy and Hold
• Index Funds

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Market Efficiency and Portfolio Management

• Even if the market is efficient a role exists for
  portfolio management
• Appropriate risk level
• Tax considerations
• Other considerations