Topic 14: The Efficient Markets Hypothesis

Question 1

What is the efficient markets hypnothesis? How does it compare to myopic expectations?

Answer 1

The efficient market hypnothesis assumes all agents know the model themselves, and so make the most optimal decisions they can given their information. The stock prices / asset prices represent the present value of the expected future stream of dividend payments.

In myopic expecations, people just assume prices won’t change.

Question 2

Under the efficient market hypnothesis, can there be bubbles?

Answer 2

Nope! and the existance of bubbles has spawned new fields of behavioral finance & behavioural macroeconomics.

Question 3

What are the implications of the Efficient Markets Hypothesis?

Answer 3

• Rational expectations are correct on average. There is error, but no systemic bias. Errors that do occur are uncorrelated with all avaliable information.
• Behavior mirrors modelling: if there is a methodological discovery based on market modeling, markets will observe this and chagne their behavior. This invalidates the model.
• There are no unexploited trading opportunities
• Current asset prices are suitable for use in blaance sheets.

Question 4

What evidence is there in support of the efficient markets hypnothesis?

Answer 4

1. Investment analysts and mutual funds don’t beat the market.
2. The stock market is most consistent with a random walk model.
3. Technical analysts who emphasis psychological attitudes to price levels and movements are not able to outperform the market on average.

Question 5

What evidence is there against the efficient markets hypothesis?

Answer 5

1. Small firm effect: small firms have abnormally high returns, even accounting for riskyness. (possibly due to large information costs)
2. The January effect - stock prices tend to rise December-January. Tax cycle issue might explain this in the US.
3. Trading in the absense of news. Even when there is no public news high trading volumes are still observed.
4. Overreaction to news. Tests suggest that markets over-react to news, ‘overshooting’.
5. Excess Volatility. Stock prices have larger amplitude than their fundamenbtal value would suggest, even accounting for risk.

Question 6

What explains shillers findings of larger then expected stock market volatility?

Answer 6

• The discount rate is not constant.
• Endogenous saving (more saving during boom times)
• The EFH may be wrong.

Question 7

What does behavioral finance & macroeconomics say about the EMH?

Answer 7

• Loss aversion makes investors adverse to short selling
• Investors tend to back their own judgement against the market, EMH not withstanding. Explains the large volume of trades without information.
• Herds and contagion. The enthusiasm of others yeilds a sense of not wanting to miss out on gains and so heard behavior pushes prices beyond fundamentals.

Question 8

What are the policy consequences of excess asset volatility?

Answer 8

1. Asset markets requirer tighter regulation then product markets.
2. Microeconomic reforms that create asset marketes might not be such a great idea; ex, carbon tax might be a better policy then an ETS.