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05-Efficient Market Hypothesis and Variance

05-Efficient Market Hypothesis and Variance - Efficient...

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BKM: 8.1, 8.2 Efficient market Hypothesis
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Apparent Patterns in Prices 0 200 400 600 800 1000 1200 1400 1600 1800 2000
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Random Walk in Prices Math review: ln(x)-ln(y)=ln(x/y) But then this implies that the stated rate with continuous compounding follows a constant+white noise process! To a reasonable approximation we can say that the effective excess return also follows a constant plus white noise process. t t t k P P ε + = - - ) ln( ) ln( 1 t t t k P P ε + = - ) / ln( 1
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Which is the Real S&P 500? 0 200 400 600 800 1000 1200 1400 1600 1800 2000
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Efficient market Hypothesis The finding that returns follow a “constant + white noise” process is the necessary consequence of intelligent investors competing to discover relevant information. Efficient Market Hypothesis: As soon as new information is revealed, prices immediately adjust to reflect that information so that E[r e ] for any stock equals the fair risk premium for that stock. That is, excess returns follow a constant+white noise process. k r E k r e t t e t = + = ] [ ε
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Three Versions of the Efficient Market Hypothesis Weak-Form EMH Stock prices immediately reflect all information contained in the history of stock trading. Semistrong-Form EMH Stock prices immediately reflect all publicly-available information. Strong-Form EMH Stock prices immediately reflect all relevant information including inside information.
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Three Versions of the Efficient Market Hypothesis Past prices are a subset of public information Public information is a subset of all information. Hence: What if markets are semistrong-form efficient. What do we know about weak-form efficiency? The market must also be weak-form efficient.
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