ECON 3420 Notes 5a [EMH – Supplementary Notes]

ECON 3420 Notes 5a [EMH – Supplementary...

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1 Efficient Market Hypothesis (EMH) – Supplementary Notes Theory 1. Information Collection Is Costly - Concerns semi-strong form EMH - Some traders choose to collect and analyze information, while others do not. The gross return of the informed is higher than that of the uninformed, but net of information cost, they end up earning the same return. 2. Noise Trader and Smart Money - Shleifer and Vishny (1997): - Arbitraging fails particularly in today’s financial markets where traders who have the power to move prices are actually managers of “other people’s money”. - Arbitraging may make their short-run performance look very bad such that investors might withdraw money from them and they could run out of capital to persist in their positions. Prices were therefore not restored to their “right” levels within a short time. - The capital requirement and the risk involved in arbitraging made the modern day markets inefficient. Empirical Studies 1. Trading Rules - Decide when to buy and sell given observed price movements, e.g. filter rule. - Weak form EMH: Trading rules cannot generate superior returns relative to a simple “buy-and-hold” strategy. - Alexander (1961), Fama and Blume (1966): - Insensitive filters (x>1.5%): Filter rule could not beat buy-and-hold. - Sensitive filters (x<1.5%): Filter rule offered some slight profit advantage but the small excess gain was completely eliminated by the transaction cost of frequent trading. - Weak form EMH was not violated. 2. Volatility - If weak form EMH holds, the variance of the ex post rational price must be larger than that of the actual price.
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2 - Shiller (1981): - Using (1) Standard and Poor's Composite Stock Price Index from 1871-1979 and (2) Modified Dow Industrial Average from 1928-1979. - Series were aggregates, annual (taking January prices), and very long. - Weak form EMH was violated in both samples. - Stock prices fluctuated much more than what could be explained by subsequent changes in dividends. - LeRoy and Porter (1981): - Similar tests - Weak form EMH was violated. 3.
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This note was uploaded on 03/03/2012 for the course ECON 3420 taught by Professor Kwong during the Spring '11 term at CUHK.

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ECON 3420 Notes 5a [EMH &acirc;€“ Supplementary...

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