Lesson 4: Efficient Markets Hypothesis (EMH)

Question 1

What is the efficient market hypothesis?

Answer 1

A statement that it is difficult or impossible to beat the stock market.

Question 2

What are the three forms of the Efficient Markets Hypothesis (EMH)?

Answer 2

1. Weak form
2. Semi-strong form
3. Strong form

Question 3

What does the weak form efficiency say?

Answer 3

Prices reflect information contained in past prices. It is not possible to profit based in information of past prices.

Question 4

What does the semi-strong form efficiency say?

Answer 4

In addition to information contained in past prices, prices reflect publicly available information, such as financial statements and news. It is not possible to profit based on public information.

Question 5

What does the strong form efficiency say?

Answer 5

In addition to information contained in past prices and publicly available information, prices reflect private information. It is impossible to beat the market except by luck.

Question 6

What are the implications of EMH?

Answer 6

1. Investors can generate NPV only if there are barriers to trade or if an investor has unique opportunities that are very hard to replicate.
2. Investors buy shares at a fair price even if they have no information about the company.
3. Companies do not increase their value with accounting tricks.
4. Companies can only gain value by investing in positive-NPV projects.
5. Companies should finance positive-NPV projects without fear that selling equity will lower the value of the company.

Question 7

What is evidence for weak form efficiency?

Answer 7

Stock prices follow random walk

Question 8

What is evidence for semi-strong form efficiency?

Answer 8

Takeover announcements are reflected immediately in price.

Question 9

What is evidence of strong form efficiency?

Answer 9

Most fund managers don’t beat the market.

Question 10

What is the January effect?

Answer 10

Returns are higher in January, lower in December.

Question 11

What is the Monday effect?

Answer 11

Returns are lower on Monday, higher on Friday.

Question 12

What is the time-of-day effect?

Answer 12

Returns are more volatile at market opening and closing times.

Question 13

What is evidence against EMH?

Answer 13

1. Calendar/time anomalies
2. Reaction to information anomalies
3. Siamese Twins and political cycle

Question 14

What is the IPO anomaly?

Answer 14

New issues (IPOs) have high returns on the first day, but underperform stocks of firms with unexpected bad earnings over a 6-month period following announcement.

Question 15

What is the earnings anomaly?

Answer 15

Stocks of firms with unexpected good earnings outperformed stocks of firms with unexpected bad earnings over a 6-month period following announcement.

Question 16

What is the momentum anomaly?

Answer 16

Positive returns followed by positive returns. Another is the mean-reversion effect (positive returns followed by negative returns).

Question 17

What is the Siamese twin anomaly?

Answer 17

Two stocks with claims on the same cash flows do not trade at same price.

Question 18

What is the political cycle anomaly?

Answer 18

First and last years of political administration have better return.