ECON 3420 Notes 4 [EMH 1]

ECON 3420 Notes 4 [EMH 1] - EMH-Theory What we have done so...

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EMH-Theory What we have done so far are static analyses. We investigated how asset prices are determined in equilibrium. This type of analyses is most suitable for explaining prices of different assets in a cross section. In the present chapter, we shift attention to studying price movements. We study how the price of a single asset moves with time. This necessitates a dynamic analysis of price determination. The most influential theory in the study of dynamic price movements is the efficient market hypothesis. According to this hypothesis, prices are driven by information. Traders in the market are assumed to use all available information to make forecasts on prices and based on these forecasts they make trading actions. Because they are quick in their action and because there are many traders, prices move quickly and the prices that we observe actually reflect all available information. This hypothesis has many implications, including some rather absurd ones. Because the implications of the EMH are so strong, economists have been attracted to testing them for more than four decades. The results are mixed. The general trend is that more and more instances have been identified where EMH fails the empirical tests (i.e. market anomalies). The market appears to make frequent mistakes in the pricing of assets (i.e the price of an asset does not reflect all available information. For instance, if the market were efficient, stock prices should not have dropped that much in the past 18 months, bearing in mind that the economy is bound to recover in the long term.) Unfortunately, although we know that the EMH does not hold strictly in the real world, no alternative theory has emerged to replace it. At present, this is still an area where much active research is going on (for example, the growing area of behavioural finance has much to do with this.) 1. The Main Ideas Consider a stock market with a large number of investors. At time t , the investors possess information contained in an information set, t . Based on this information set, they make a forecast of the price of a stock at time t +1, E( p t+1  t ). Ignoring dividends and discounting, they would follow a simple buy-sell decision rule -- buy if expected tomorrow’s price is higher than current price, i.e. E( p t+1  t ) > p t and sell if lower, i.e. E( p t+1  t ) < p t . Since all investors behave in this way, they have access to the same information and they interpret the information in the same way, in equilibrium E( p t+1  t ) = p t . (*) This is the simplest statement of the Efficient Market Hypothesis (EMH). Current price adjusts until it is equal to the expected future price. In other words, current price is an unbiased predictor (or unbiased forecast) of future price. [Furthermore, as the expectation operator in (*) is conditional on all available information, current price is not only an unbiased predictor, but the best unbiased predictor.] In determining price, the market is efficient in capturing all available
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ECON 3420 Notes 4 [EMH 1] - EMH-Theory What we have done so...

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