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CHAPTER 6 EFFICIENT CAPITAL MARKETS Answers to Questions 1. There are several reasons why one would expect capital markets to be efficient, the foremost being that there are a large number of independent, profit-maximizing investors engaged in the analysis and valuation of securities. A second assumption is that new information comes to the market in a random fashion. The third assumption is that the numerous profit- maximizing investors will adjust security prices rapidly to reflect this new information. Thus, price changes would be independent and random. Finally, because stock prices reflect all information, one would expect prevailing prices to reflect “true” current value. Capital markets as a whole are generally expected to be efficient, but the markets for some securities might not be as efficient as others. Recall that markets are expected to be efficient because there are a large number of investors who receive new information and analyze its effect on security values. If there is a difference in the number of analysts following a stock and the volume of trading, one could conceive of differences in the efficiency of the markets. For example, new information regarding actively traded stocks such as IBM and Exxon is well publicized and numerous analysts evaluate the effect. Therefore, one should expect the prices for these stocks to adjust rapidly and fully reflect the new information. On the other hand, new information regarding a stock with a small number of stockholders and low trading volume will not be as well publicized and few analysts follow such firms. Therefore, prices may not adjust as rapidly to new information and the possibility of finding a temporarily undervalued stock are also greater. Some also argue that the size of the firms is another factor to differentiate the efficiency of stocks. Specifically, it is believed that the markets for stocks of small firms are less efficient than that of large firms. 2. The weak-form efficient market hypothesis contends that current stock prices reflect all available security-market information including the historical sequence of prices, price changes, and any volume information. The implication is that there should be no relationship between past price changes and future price changes. Therefore, any trading rule that uses past market data alone should be of little value. The two groups of tests of the weak-form EMH are (1) statistical tests of independence and (2) tests of trading rules. Statistical tests of independence can be divided further into two groups: the autocorrelation tests and the runs tests. The autocorrelation tests are used to test the existence of significant correlation, whether positive or negative, of price changes on a particular day with a series of consecutive previous days. The runs tests examine the sequence of positive and negative changes in a series and attempt to determine the existence of a pattern. For a random series one would expect 1/3(2n - 1) runs, where n is the number of
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This note was uploaded on 05/20/2010 for the course FIN 5DLS taught by Professor Leejohn during the One '10 term at La Trobe University.

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