Efficient Market Hypothesis Flashcards
What does the EMH state about stock prices?
The EMH states that stock prices fully reflect all available information, meaning they follow a random walk and cannot be consistently predicted for excess returns.
How does the present-value relation link stock prices to dividends?
In an efficient market, stock prices should equal the conditional expectation of the present value of all future dividends, discounted at a risk-adjusted rate.
What does the variance bounds test examine?
It compares the variance of stock prices to the variance of the ex post present value of future dividends. If prices are more volatile than justified by dividends, the EMH may be questioned.
How is the ex post present value of dividends calculated?
It is calculated after the fact by discounting actual dividends at an appropriate rate to see if they align with past stock prices.
Why should the forecast error and the present value of dividends be uncorrelated in an efficient market?
Because if stock prices are truly the best estimates of future dividends, any error in predicting dividends should be random and not systematically related to stock prices.
What does it mean when variance bounds are violated?
It means stock price variance exceeds the variance of the ex post present value of dividends, suggesting that prices may be too volatile compared to fundamental values.
How does dividend smoothing impact the variance bounds test?
If firms smooth dividends, stock prices may react more to expected future earnings, leading to higher price volatility and a possible variance bound violation.
How does investor risk aversion lead to variance bound violations?
If investors are risk-averse, they demand a higher risk-adjusted return, which lowers stock prices and increases their volatility as risk perceptions change.
What are alternative explanations for variance bound violations?
1) Dividend smoothing ( Marsh and Merton (1986))
2) Risk aversion (Michener (1982))
3) Sampling issues (some argue that small data samples can falsely suggest violations).
Why does the variance bounds violation challenge the EMH?
If prices move too much compared to fundamentals, it suggests that factors other than available information (like speculation) may be driving prices, contradicting the random walk assumption of EMH.
What is the Random Walk Hypothesis (RWH)?
The RWH suggests that stock price movements are random and unpredictable, reflecting all available information at any point in time. Price changes follow a random sequence and cannot be forecasted.
What is the role of “frictionless markets” in the EMH?
In the EMH, frictionless markets mean there are no transaction costs, and information is absorbed instantly by prices, ensuring that no one can consistently profit from new information.
What is the concept of “easy profits” in market theory?
“Easy profits” refer to profits that can be made by using available information to predict price changes in an inefficient market. The EMH suggests that these profits are impossible because prices already reflect all information.
What is the significance of dividend smoothing in relation to the EMH?
Dividend smoothing occurs when companies adjust dividend payments to maintain stability, even if it doesn’t reflect true future performance. This can affect stock price volatility and lead to variance bound violations, which can be consistent with the EMH if investors are risk-averse.
What does overreaction in the market refer to?
Overreaction refers to when investors overreact to new information, buying stocks of companies that have performed well recently or selling stocks of companies that have performed poorly, pushing prices beyond their “fair” or “rational” market value.
What are the implications of overreaction in the market?
Overreaction leads to price reversals, meaning stocks that go up will eventually come down, and vice versa. This also implies that contrarian investment strategies (buying “losers” and selling “winners”) can yield superior returns.
How was overreaction tested and confirmed empirically?
DeBondt and Thaler (1985) used monthly returns from the New York Stock Exchange (NYSE) from 1926 to 1982 and found that stocks that were “winners” in one period tended to reverse their performance in the next period.
What is a contrarian investment strategy?
A contrarian investment strategy involves buying stocks that have performed poorly (losers) and selling stocks that have performed well (winners), based on the idea that overreaction in the market will cause prices to reverse.
What did Lehmann (1990) show about contrarian strategies?
Lehmann (1990) demonstrated that a zero-net-investment strategy (buying losers and shorting winners) almost always yields positive returns using NYSE/AMEX stock returns data from 1962 to 1985.
How did Chan (1988) challenge the profitability of contrarian strategies?
Chan (1988) argued that the profitability of contrarian strategies cannot be used as conclusive evidence against the EMH because it does not account for risk. By risk-adjusting the returns using the capital asset pricing model (CAPM), he showed that expected returns were consistent with the EMH.
