Econ2035_Ch7

Good performance in the past does not indicate that

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Unformatted text preview: nt Market Hypothesis •  Under the ra7onal expecta7on, if the expected price equals the op7mal forecast, then the expected return equals also the op7mal forecast. ⇒ The expected return (Re) = The op7mal forecast of return (Rop) •  Demand and supply analysis suggests that the market will be heading to the equilibrium. ⇒ The expected return (Re) = The equilibrium return (R*) •  Therefore, we have R* = Rop 17 The Efficiency Market Hypothesis •  R* = Rop Current prices in a financial market will be set so that the op7mal forecast of a security’s return using all available informa7on equals the security’s equilibrium return •  Put it simply, In an efficient market, a security’s price fully reflects all available informaMon 18 The Efficiency Market Hypothesis •  Zero Unexploited Profit Opportunity –  Suppose a stock has Rop > R* for some reason –  We call this situa7on an unexploited profit opportunity, where people would be earning more than they should (=R*) –  Pt↑ ⇒ Rop↓ un7l Rop = R* –  As a result, in an efficient market, all unexploited profit opportuni7es will be eliminated 19 Favorable Evidence for Market Efficiency •  Performance of investment analysts and mutual funds –  Cannot beat the market! –  Good performance in the past does not indicate that it will be true in the future •  If informa7on is already publically available, a posi7ve announcement does not cause stock prices to rise, on average (It is already reflected in the current price) •  Stock prices follow a random walk, so that their movements are unpredictable 20 Evidence Against Market Efficiency •  Small firm effect Small firms have ea...
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