Lecture08 Market Efficiency

Lecture08 Market Efficiency - Market Efciency Tyler R...

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Market Efficiency Tyler R. Henry 1 FINA 4310 Outline Contents 1 Forms of EMH 1 1.1 Weak Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1.2 Semistrong Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 1.3 Strong Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2 Testing EMH 6 2.1 Weak Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2.2 Semistrong Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.3 Interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 1 Forms of EMH Definitions Efficient Capital Market : A market in which prices reflect all available infor- mation. Perfect Capital Market : A perfectly competitive and informationally efficient market in which there are no market frictions (e.g., no transaction costs or taxes). Note that efficient markets are not necessarily perfect markets. A perfect capital market is a stronger condition. (Many theories in finance assume perfect capital markets). The Efficient Market Hypothesis (EMH) In the New Palgrave Dictionary of Money and Finance , Burton Malkiel offers the following definition of market efficiency: A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. 1
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Formally, the market is said to be efficient with respect to some information set . . . if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set . . . implies that it is impossible to make economic profits by trading on the basis of that information set. Information Signals The firm Financial statements Business plans Specific announcements Competitors and suppliers Competition Market share Product quality The macro economy GNP growth Employment Industrial production The investment and brokerage community Security analysis Earnings and dividend forecasts Value assessments Buy and sell recommendations Three Forms of the Efficient Market Hypothesis Tests of the efficient market hypothesis require the researcher to define the infor- mation set . We define three forms of the EMH which differ in their definition of the relevant information set: – Weak-form EMH : The weak-form information set (denoted by Φ w ) in- cludes the history of all security prices and returns. 2
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– Semistrong-form EMH : The semistrong-form information set (denoted by Φ ss ) includes all publicly available information. Note that Φ w Φ ss . – Strong-form EMH : The strong-form information set (denoted by Φ s ) in- cludes all information known to any market participant (i.e., public and private information). Note that Φ ss Φ s . Efficient Market Hypothesis (EMH) Efficient Market Hypothesis (EMH Efficient Market Hypothesis (EMH) Strong Semistrong Weak 10/22/07 FINA 4310 4 1.1 Weak Form Weak Form EMH Weak form efficiency is generally synonymous with the random walk theory . A random walk is a statistical process, whereby successive prices are independent of each other. The theory states that changes in stock prices are statistically random, thus implying that there is no pattern to stock prices.
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This note was uploaded on 06/06/2011 for the course FINA 4310 taught by Professor Staff during the Spring '08 term at UGA.

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Lecture08 Market Efficiency - Market Efciency Tyler R...

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