Two Pillars of Asset pricing

Question 1

Three phases of efficient market hypothesis

Answer 1

Strong
Semi-strong
Weak

Question 2

Strong EMH

Answer 2

prices incorporate all information (also

non-public)

Question 3

Semi-strong EMH

Answer 3

only public information is

incorporated in prices

Question 4

Weak EMH

Answer 4

prices incorporate only information of

past price movements

Question 5

The problem in EMH

Answer 5

We want to know whether markets are efficient
→ we need to determine what is “efficient” →
we use a model to test the efficiency →
Imagine the model shows that markets are NOT
efficient:
a) Model is wrong and we have to test markets again
b) Model is correct and markets are inefficient
→ Joint hypothesis problem

Question 6

Joint Hypothesis problem

Answer 6

The Joint Hypothesis problem refers to that testing for market efficiency is problematic, or even impossible. Any attempts to test for market (in)efficiency must involve an equilibrium asset pricing models. It is not possible to measure ‘abnormal’ returns without expected returns predicted by pricing models.

Question 7

Joint Hypothesis problem in case of inflation

Answer 7

Expected stock returns are higher when expected
inflation is lower; so we have JHP:
– Poor inflation forecasts (so markets are inefficient) or
– Or our model is wrong and actually we should expect
such strange relationship AND markets are efficient