Efficient Market Hypothesis

Question 1

What is the Efficient Market Hypothesis (EMH)?

Answer 1

The EMH states that stock prices fully reflect all available information, making it impossible to consistently outperform the market

Question 2

What are the three forms of EMH?

Answer 2

1. Weak Form – Prices reflect past trading data.
   
   2. Semi-Strong Form – Prices reflect all publicly available information.
   3. Strong Form – Prices reflect all public and private information.

Question 3

What is the key implication of the Weak Form of EMH?

Answer 3

Technical analysis is ineffective because past price movements are already reflected in current prices.

Question 4

What is the key implication of the Semi-Strong Form of EMH?

Answer 4

Fundamental analysis is ineffective because public information is already incorporated into stock prices.

Question 5

What is the key implication of the Strong Form of EMH?

Answer 5

Insider trading would not provide an advantage because all information (public and private) is reflected in stock prices.

Question 6

What are the key conditions for a market to be efficient?

Answer 6

• Large number of rational investors.
  
  • Information is costless and available to everyone at the same time.
  • Investors react quickly to new information.

Question 7

What is the Random Walk Hypothesis?

Answer 7

The idea that stock prices move randomly because new information is unpredictable.

Question 8

How does the Random Walk Hypothesis support EMH?

Answer 8

If information is reflected immediately in prices, future price movements become unpredictable and random.

Question 9

What are examples of market anomalies that challenge the Semi-Strong Form of EMH?

Answer 9

• January Effect (higher returns in January).
  
  • Small-Firm Effect (small stocks outperform large stocks).
  • Post-Earnings Announcement Drift (prices continue moving after good/bad news).

Question 10

What are the common methods used in Technical Analysis (testing Weak Form)?

Answer 10

• Moving Averages
  
  • Relative Strength Index (RSI)
  • MACD (Moving Average Convergence Divergence)
  • Stochastic Oscillator

Question 11

What is the Moving Average used for?

Answer 11

To smooth out price data and identify trends. A buy signal occurs when the price rises above the moving average.

Question 12

What does the RSI (Relative Strength Index) measure?

Answer 12

Momentum – RSI above 70 indicates an overbought market; below 30 indicates an oversold market.

Question 13

What are the key statistical tests used to test Weak Form EMH?

Answer 13

• Autocorrelation Tests – Check for correlation in returns.
  
  • Runs Tests – Test randomness of price changes.
  • Unit Root Tests – Test for non-random behavior.

Question 14

How are event studies used to test Semi-Strong Form EMH?

Answer 14

Analyze how quickly stock prices adjust to significant public news (e.g., earnings announcements).

Question 15

How do insider trading studies challenge the Strong Form of EMH?

Answer 15

If insiders can consistently profit, the market is not fully efficient at the strong-form level.

Question 16

What did Jaffe (1974) and Seyhun (1986) discover about insider trading?

Answer 16

Insiders tend to buy before positive news and sell before negative news, contradicting strong-form EMH.

Question 17

What is the implication of EMH for portfolio management?

Answer 17

Passive strategies (e.g., index funds) are more effective than active management.
* Diversification is essential to reduce unsystematic risk.

Question 18

What are the benefits of passive management under EMH?

Answer 18

• Lower costs.
  
  • Market-matching returns.
  • No need for constant monitoring.

Question 19

Why do large investors still engage in active management despite EMH?

Answer 19

• They have access to better data and resources.
  
  • Their actions contribute to market efficiency.

Question 20

What is the difference between technical and fundamental analysis?

Answer 20

Technical analysis – Uses past price data to predict future movements.
* Fundamental analysis – Uses financial and economic data to value stocks.

Question 21

Why does technical analysis fail under Weak Form EMH?

Answer 21

Past price patterns are already reflected in current prices, so they provide no predictive power

Question 22

Why does fundamental analysis fail under Semi-Strong Form EMH?

Answer 22

Public information is already reflected in stock prices, leaving no opportunity for excess returns.

Question 23

How does market efficiency affect stock price reaction to news?

Answer 23

Prices adjust immediately, leaving no room to profit from public news

Question 24

What are the key challenges to testing EMH?

Answer 24

• Trading costs.
  
  • Information lag.
  • Complexity of financial markets.

Question 25

Why do some investors still use active management despite EMH?

Answer 25

Psychological biases and overconfidence often lead investors to believe they can “beat the market.”

Question 26

What is the conclusion regarding EMH based on empirical evidence?

Answer 26

Weak Form – Generally supported. * Semi-Strong Form – Supported, but challenged by anomalies. * Strong Form – Largely unsupported due to insider trading evidence.