Efficient Market hypothesis Flashcards
Essay Plan- Efficient Market Hypothesis (EMH)
1.Explain what EMH is.
2.Main assumptions (market
conditions e.g. arbitrage etc).
3.Main forms (weak or strong etc).
4.Implications for managers.
Efficient market hypothesis
A market where prices ‘fully reflect available information’
Explain what this mean ‘A market where prices ‘fully reflect available information’’.
Prices immediately respond to new information and knowing information does not allow for abnormal returns
Efficient market diagram
See flashcard. Explain each bit.
What are the three market conditions that lead to efficiency?
- Rationality
2.Independant deviations
3.Arbitrage
Rationality
Assumption that participants in financial markets act logically and consistently.
Rationality example
If NPV of new project is 10mil price there are 2mil shares. Investors assume £5 per share. If old share price is £40. They will be now happy to pay up to £45 per share.
Independent deviations
Assumption that some investors will deviate from rational behaviour either optimistically or pessimistically. However for an efficient market these will balance. Irrationality is not systematically biased.
Independent deviations example
If as many investors were irrationally pessimistic as were optimistic, prices would rise in a manner consistent with market efficiency.
Arbitrage
The practice of profiting from price discrepancies. Buying an asset at a lower price in one market and sell it at a higher price in another market. The profit is the difference between the two prices.
Arbitrage EMH
Highly skilled professionals can correct price changes within the market that are cause by amateurs making irrational decisions. The arbitrage of professional dominates the speculation of amateurs to create an efficient market.
Main forms of efficiency
- Weak
- Semi strong
- Strong
The weak form
Securities prices reflect all past information. Technical trading does not work.
Past information used in a weak market
-Security price patterns
-Trading volume
-Volatility of security price returns.
Why is it weak?
Beacause historical price info is the easiest to attain. E.g. if your stock has risen the past 5 days this doesn’t mean it will rise on the 6th.
Semi-strong
-Security prices reflect all information
publicly available.
-Prices adjust almost immediately
with new public information.
Information in a semi strong market
-Past share price
-Accounting information
-Economic and industry forecasts
-News announcements e.g. takeovers
or security issuance.
Strong form
Share prices incorporate all information.
Information in a strong form market
-Past share price data
-Publicly available information
-Privately held data i.e. company
directors’ inside info
Implications of a strong form market for investors
Insider information can not be used to generate abnormal returns from trading.
Implications of EMH for managers
-Accounting has no impact on prices.
-Cannot time security issuance
-No price pressure effect
-Can trust market prices
Accounting choice have no impact
Unless reporting fraudulently the choice of accounting method will not allow manipulation of stock price.
Managers cannot time security issuance.
In an efficient market the prices adjust quickly. Managers cant benefit from trying to time he market when issuing stocks or shares. Financing is a zero NPV project.
No price pressure effects
Managers don’t need to worry about price distortions caused by their corporate actions. Companies can share as many shares as necessary. Market prices will adjust.
Can trust market prices
No bargains in financial markets for managers to capitalize on. Prices reflect all available information.
