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Chap008 - Chapter 08 The Efficient Market Hypothesis...

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Chapter 08 - The Efficient Market Hypothesis CHAPTER EIGHT THE EFFICIENT MARKET HYPOTHESIS CHAPTER OVERVIEW This chapter examines the concept of market efficiency. We are asking whether securities are on average fairly priced according to the benefits they give an investor. If they are then one cannot expect to consistently earn more than you should for the risk level you are taking. In other words you cannot consistently beat the market’s risk-adjusted return. There are two aspects of efficiency although the text does not explicitly separate the two. In an informationally efficient market, price changes are unpredictable. It is this aspect of efficiency that the text is concerned with. However we may also ask a related question, “Are the markets efficient allocators of capital?” In other words do market prices accurately reflect the current worth of risk adjusted expected future cash flows? If they do then the markets are allocationally efficient. Markets could be allocationally inefficient, but still be informationally efficient. This may arise due to behavioral problems discussed in Chapter 9 or due to structural market problems. We will have more to say on this later. LEARNING OBJECTIVES After studying this chapter, the student should thoroughly understand the concept of informational market efficiency and how to make rational investment decisions based upon the existence of market efficiency. The student also should have a working knowledge of some of the many tests of market efficiency, the forms of market efficiency, and observed market anomalies. Market efficiency is akin to the perfect competition model to which it is related. Like perfect competition, it should be interpreted as an ideal that markets move toward but probably will never totally achieve at all times. Nevertheless the financial markets are highly competitive and it is likely that markets will closely approach efficiency, the occasional bubbles notwithstanding. Bubbles remind us that math and models of cash flows, etc., do not drive financial asset prices, but rather, people do. The most telling lesson of this chapter is not that you can never find a great buy, but rather if you find a great buy, you should grab it quickly and don’t expect to find very many such buys in the competitive markets we have. CHAPTER OUTLINE 1. Random Walks and the Efficient Market Hypothesis PPT 8-2 through PPT 8-14 8-1
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Chapter 08 - The Efficient Market Hypothesis Definitions of informational and allocational efficiency are provided. Implications of efficiency are then discussed and the idea of random walk is introduced and illustrated. Note that we actually expect there to be a positive trend in stock prices albeit with random movements about those positive trends. The reason that we would expect to see price changes that are random is related to efficiency. If information that has importance for stock values arrives or occurs in a random fashion, price changes will occur randomly. If the market is efficient in its analysis, the change in prices will reflect that information in a timely basis.
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