Week 9 - Efficient Market Hypothesis Flashcards
What does the Efficient Mkt Hypothesis assert?
Prices in money and capital markets are efficient.
- Current market prices reflect all available information
- It is impossible to earn excess returns by using information available to the market to guide your trading
- Information is rapidly and accurately disseminated
- It is not possible to predict price changes by using current information
What is the Fair Game Model?
εt+1 = rt+1 − E(rt+1|Ωt)
Where:
- > εt+1 = the difference between an observed return and its predicted value
- > Ωt is information at time t
- > E(rt+1|Ωt) is the rational expectation of a return at time, given information available at time t
How do we define εt+1 as a fair game?
In an efficient market we should find E(εt+1|Ωt) = 0
(Essentially returns unpredictable)
This defines εt+1 as a fair game.
How do we calculate the Martingale Property
E(pt+1|Ωt) = pt
INFO = PRICE CHANGES
-> If prices follow the property then returns are a fair game -> Expected Value = 0
-> Essentially from all info tomorrow’s price = today’s price -> Info random prices
What does the Martingale Property mean?
means that a return at one date gives no
information about the return at any other date.
Returns should not be serially correlated.
Zero serial correlation supports EMH
Why do we use Sub-Martingale?
Since returns are always increasing over time
SEE EQUATION IN NOTES
What is a Random Walk?
Results independent of what happened before -> News is random so is price
- Follows Martingale Property
Why Cycles self destructive?
Self-destruct soon as recognised by investors - Price jumps to PV of expected future price
Thus, you cannot completely predict prices since moment you notice it so has everyone else
What are the 3 levels of Efficiency?
- > Weak Form: share prices reflect all current and past information on prices and returns, or market trading data in general.
- > Semi-strong form: share prices reflect all current and past public information
- > Strong form: all current and past information, public or private.
What are the 3 implications of EMH?
- Info search pointless
- What’s the point of active investment
- Resource Allocation
What is meant by infomation search is pointless (1st implication of EMH)
-> If mkts efficient, why spend resources looking for inefficiency -.> This not rational -> But if people not rational, prices inefficient (THIS IS THE EMH PARADOX (1))
-> Fundamental Analysis also pointless -> If mkt price already embodies fundamental info, why do fundamental info again?
(THIS IS EMH PARADOX (2))
How is the EMH Paradox (1) solved by Grossman-Stiglitz?
->Efficiency is not an “all-or-nothing” matter.
->Investors spend resources until the marginal cost of gathering and processing information is just equal to the marginal
benefit.
What is meant by what’s the point of active investment (2nd implication of EMH)
- > Professional portfolio managers have no informational advantages over other investors
- > Better to invest in index fund -> Cheaper costs
If active management doesn’t help ‘beat the mkt’ why is it still used?
Professional portfolio managers may not have special information but they can design portfolios for specific purposes:
- Tax efficiency
- Particular levels of systematic risk for example by holding specific positions in treasury bills
“Beating the market” need not be the goal of portfolio
management
What is meant by Resource Allocation (3rd implication of EMH)
->If asset prices are mispriced, then incorrect signals are sent to the market, to investors and to firms.
Cash may flow into over-valued activities:
the dot.com bubble of late 1990s led to over-investment in firms in IT industries.
