Two Pillars of Asset Pricing, American Economic Review

Question 1

The three EMH forms

Answer 1

1. Strong: prices incorporate all information, public and non-public
2. Semi-strong: prices implement all public information
3. Weak: prices incorporate all information of past price movements

Question 2

The three EMH arguments

Answer 2

1. Investors are rational
2. Irrational investors cancel each other out b/c random
3. Even when they don’t cancel out, arbitreurs take advantage and the irrational make loses

Question 3

What’s the Joint Hypothesis Problem?

Answer 3

1. We need to know WHAT the market is supposed to do to know whether it does it.
2. Less of a problem in short time horizons.
3. Testing EMH we need to make assumptions on the other models (market model, CAPM, ICAPM, etc).

Question 4

Conclusion from Irving Fisher (“Market efficiency”) hypothesis

Answer 4

Expected returns are high when business conditions are poor and low when they are strong.

Question 5

“bubbles”

Answer 5

irrational strong price increase that implies a predictable strong decline.

Question 6

Critique on models related to behavioural finance

Answer 6

The behavioural literature has not put forth a full blown model for prices and returns that can be tested and potentially rejected – the acid test for any model proposed as a replacement for another model.