Efficient Market Hypothesis Flashcards
What is the Efficient Market Hypothesis (EMH)?
The EMH states that stock prices fully reflect all available information, making it impossible to consistently outperform the market
What are the three forms of EMH?
- Weak Form – Prices reflect past trading data.
- Semi-Strong Form – Prices reflect all publicly available information.
- Strong Form – Prices reflect all public and private information.
What is the key implication of the Weak Form of EMH?
Technical analysis is ineffective because past price movements are already reflected in current prices.
What is the key implication of the Semi-Strong Form of EMH?
Fundamental analysis is ineffective because public information is already incorporated into stock prices.
What is the key implication of the Strong Form of EMH?
Insider trading would not provide an advantage because all information (public and private) is reflected in stock prices.
What are the key conditions for a market to be efficient?
- Large number of rational investors.
- Information is costless and available to everyone at the same time.
- Investors react quickly to new information.
What is the Random Walk Hypothesis?
The idea that stock prices move randomly because new information is unpredictable.
How does the Random Walk Hypothesis support EMH?
If information is reflected immediately in prices, future price movements become unpredictable and random.
What are examples of market anomalies that challenge the Semi-Strong Form of EMH?
- 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).
What are the common methods used in Technical Analysis (testing Weak Form)?
- Moving Averages
- Relative Strength Index (RSI)
- MACD (Moving Average Convergence Divergence)
- Stochastic Oscillator
What is the Moving Average used for?
To smooth out price data and identify trends. A buy signal occurs when the price rises above the moving average.
What does the RSI (Relative Strength Index) measure?
Momentum – RSI above 70 indicates an overbought market; below 30 indicates an oversold market.
What are the key statistical tests used to test Weak Form EMH?
- Autocorrelation Tests – Check for correlation in returns.
- Runs Tests – Test randomness of price changes.
- Unit Root Tests – Test for non-random behavior.
How are event studies used to test Semi-Strong Form EMH?
Analyze how quickly stock prices adjust to significant public news (e.g., earnings announcements).
How do insider trading studies challenge the Strong Form of EMH?
If insiders can consistently profit, the market is not fully efficient at the strong-form level.
What did Jaffe (1974) and Seyhun (1986) discover about insider trading?
Insiders tend to buy before positive news and sell before negative news, contradicting strong-form EMH.
What is the implication of EMH for portfolio management?
Passive strategies (e.g., index funds) are more effective than active management.
* Diversification is essential to reduce unsystematic risk.
What are the benefits of passive management under EMH?
- Lower costs.
- Market-matching returns.
- No need for constant monitoring.
Why do large investors still engage in active management despite EMH?
- They have access to better data and resources.
- Their actions contribute to market efficiency.
What is the difference between technical and fundamental analysis?
Technical analysis – Uses past price data to predict future movements.
* Fundamental analysis – Uses financial and economic data to value stocks.
Why does technical analysis fail under Weak Form EMH?
Past price patterns are already reflected in current prices, so they provide no predictive power
Why does fundamental analysis fail under Semi-Strong Form EMH?
Public information is already reflected in stock prices, leaving no opportunity for excess returns.
How does market efficiency affect stock price reaction to news?
Prices adjust immediately, leaving no room to profit from public news
What are the key challenges to testing EMH?
- Trading costs.
- Information lag.
- Complexity of financial markets.
Why do some investors still use active management despite EMH?
Psychological biases and overconfidence often lead investors to believe they can “beat the market.”
What is the conclusion regarding EMH based on empirical evidence?
Weak Form – Generally supported.
* Semi-Strong Form – Supported, but challenged by anomalies.
* Strong Form – Largely unsupported due to insider trading evidence.
