091121_EMH - Efficient Markets Theory Lecture 12 21...

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Efficient Markets Theory Lecture 12 21 November 2009
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Efficiency: concept z Valuation efficiency Prices of securities traded on a market reflect their true fundamental values (P market = P fair ) z Informational efficiency Securities prices fully reflect all available information (P exp. = P fair ) z Allocative efficiency Market allocates productive resources to most productive investment opportunities Allocative efficiency = valuation eff. + informational eff.
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Informational efficient markets z EMH: Financial markets are efficient when security prices incorporate all available information z A market is said to be informationally efficient with respect to some information set if no agent can consistently make economic profit through the use of a trading rule based on that info set Economic profit = excess (abnormal) return Excess return = R i –E(R i ) > 0
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Joint hypothesis problem z EMH test H o : R i –E(R i ) = 0 z But in fact we have to test two hypotheses instead of 1: Informational efficiency Accuracy of the equilibrium expected return z CAPM z APT z We never know which of the two sub- hypotheses is wrong
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Joint hypothesis problem z Case 1: Markets are in fact informationally efficient, but the model for calculating expected returns is wrong Reject the correct hypothesis (Type I error) z Case 2: Markets are informationally inefficient, but the model for calculating expected returns is wrong – a combination, which by some coincidence leads to the absence of excess returns Accept the wrong hypothesis (Type II error)
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Information sets z EMH is considered w.r.t. some information set z There are three information sets: Historical data All publicly available information All information (both private and public) Historical information Public information Public and private information
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Forms of market efficiency z Weak form Prices reflect all historical information z Semi-strong form Prices reflect all publicly available information z Strong form Prices reflect all information Weak Semi- strong Strong
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Weak form efficiency: implications z Technical analysis cannot outperform the market The study of past stock price movements to
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091121_EMH - Efficient Markets Theory Lecture 12 21...

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