ch8outline - Chapter 8: The Efficient Market Hypothesis I....

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Chapter 8: The Efficient Market Hypothesis I. Random Walks and the Efficient Market Hypothesis A. The forecast of a future price increase will lead instead to an immediate price increase 1. In other words, the stock price will immediately reflect the “good news: implicit in the model’s forecast B. A forecast about favorable future performance leads instead to favorable current performance, as market participants all try to get in on the action before the price increase C. More generally, one might say that any information that could be reflected in stock prices 1. As soon as there is any information indicating that a stock is underpriced and therefore offers a profit opportunity, investors flock to buy the stock and immediately bid up its price to a fair level, where only ordinary rates of return can be expected 2. These “ordinary rates” are simply rates of return commensurate with the risk of the stock 3. However, if prices are bid immediately to fair levels, given all available information, it must be that they increase or decrease only in response to new information 4. New information must be unpredictable 5. Thus stock prices that change in response to new (unpredictable) information also must move unpredictably D. This is the essence of the argument that stock prices should follow a random walk , that is, that price changes should be random and unpredictable E. Don’t confuse randomness in price changes with irrationality in the level of prices F. Indeed, if stock price movements were predictable, that would be damning evidence of stock market inefficiency, because the ability to predict prices would indicate that all available information was not already reflected in stock prices 1. Therefore, the notion that stocks already reflect all available information is referred to as the efficient market hypothesis(EMH) G. In most takeovers, the acquiring firm pays a substantial premium over current market prices 1. Therefore, announcement of a takeover attempt should cause the stock price to jump 2. Even more dramatic evidence of rapid response to new information may be found in intraday prices H. Competition as the Source of Efficiency 1. When information is costly to in cover and analyze, one would expect investment analysis calling for such expenditures to result in an increased expected return 2. Grossman Stiglitz argued that investors will have an incentive to spend time and resources to analyze and uncover new information only if such activity is likely to generate higher investment returns 3. Moreover, it would not be surprising to find that the degree of efficiency differs across various markets 4. For example, emerging markets that are less intensively analyzed than U.S. markets and in which accounting disclosure requirements are less rigorous may be less efficient than U.S. markets
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I. Versions of the Efficient Market Hypothesis 1. It is common to distinguish among three versions of the EMH: the weak, semistrong, and strong forms of the
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This note was uploaded on 09/10/2010 for the course FIN 367 taught by Professor Han during the Fall '08 term at University of Texas at Austin.

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ch8outline - Chapter 8: The Efficient Market Hypothesis I....

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