The cml represents a new frontier of efficient

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Unformatted text preview: of transaction costs. Since information arrives at the market at any time, and the information can be good or bad, stock price movements are unpredictable and follow a random walk. T HE THREE FORMS OF MARKET EFFICIENCY Professor Eugene Fama proposes that there are 3 forms of market efficiency: 1. 2. 3. Weak form Historical price and volume data Semi-strong form Information included in the weak form All publicly available information i. Historical price and volume data ii. Macro-economic data iii. Government policies iv. Firm specific information Strong form Information included in both weak and semi-strong forms All private information known only by the company insiders Known by directors, auditors and major shareholders – who have 1st hand knowledge of corporate events unknown to the general public In all three forms of market efficiency, market participants are unable to use the information suggested to formulate trading strategies that can result in abnormal returns. Due to the need to justify whether an abnormal return is earned, any tests of the efficient market hypothesis is a joint test of market efficiency and the asset pricing model, which was used to benchmark/measure normal return. This means that finding evidence that contradicts the efficient market hypothesis does not necessarily imply that the market is inefficient – it can be due to flaws in the asset pricing model. T ESTING THE MARKET FOR WEAK FORM EFFICIENCY T ECHNICAL ANALYSIS Technical analysis tests the profitability of trading strategies, by using historical price and volume data to identify momentum or recurring patterns for the design of trading rules. These trading rules include: Relative Strength – buy if the daily ratio of the stock price to market index was rising over 5 days Filter rule – buy when the price of a stock has risen above a previous low, and hold the stock until its price falls by 5% from a subsequent high TRIN ratio – average volume of declining stocks divided by average v...
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