Chapter 11_Hand-out 10

Chapter 11_Hand-out 10 - CHAPTER 11 THE EFFICIENT MARKET...

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CHAPTER 11 THE EFFICIENT MARKET HYPOTHESIS 11.1 RANDOM WALKS AND THE EFFICIENT MARKET HYPOTHESIS Maurice Kendall (1953) examined recurrent patterns of peaks and troughs in economic performance of firms and found to his great surprise that he could identify no predictable patterns in stock prices. Prices seemed to evolve randomly . There were as likely to go up as they were to go down on any particular day, regardless of past performance. The data provided no way to predict price movements. So, the Kendall’s attempt to find recurrent patterns in stock price movements was doomed to failure. Suppose Kendall had discovered that stock prices are predictable. What a gold mine this would have been. If they could use Kendall’s equations to predict stock prices, investors would reap unending profits simply by purchasing stocks that the computer model implied were about to increase in price and by selling those stocks about to fall in price. A moment’s reflection should be enough to convince yourselves that this situation could not persist for long. Suppose that the computer model predicts with great confidence that the XYZ stock price, currently at $100 per share, will rise dramatically in three days to $110. All investors with access to the model’ prediction would place a great wave of immediate buy orders to cash in on the prospective increase in stock price, but no one holdings XYZ stock, however, will be willing to sell, and the net effect would be an immediate jump in the stock price to $110. The forecast of a future price increase leads instead to an immediate price increase. Another way of putting this is that the stock price will immediately reflect “the good news” implicit in the model’s forecast. More generally, one might say that any information that could be used to predict stock performance should already be reflected in stock prices. 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. These "ordinary rates" are simply rates of return commensurate with the risk of the stock. However, if prices are bid immediately to fair levels, given all available information, it must be that prices increase or decrease only in response to new information. New information, by definition, must be unpredictable . If it 1
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could be predicted, then the prediction would be part of today’s information. Thus stock prices that change in response to new (unpredictable) information also must move unpredictably. 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. Far from a proof of market irrationality, randomly evolving stock prices are the necessary consequence of intelligent investors competing to discover relevant information on which to buy or sell stocks before the rest of the market
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Chapter 11_Hand-out 10 - CHAPTER 11 THE EFFICIENT MARKET...

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