Chapter 12

Efficient Market Efficient MarketHypothesisHypothesis

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Efficient Markets

In an efficient stock market, the price for any In an efficient stock market, the price for any given stock effectively represents the expected given stock effectively represents the expected net present value of all future profitsnet present value of all future profits

Interplay of supply and demand sets pricesInterplay of supply and demand sets prices

Price for any stock or bond represents collective Price for any stock or bond represents collective wisdom about future prospectswisdom about future prospects

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Efficient Markets Hypothesis

EMH holds that security prices fully reflect all EMH holds that security prices fully reflect all available information at any time.available information at any time.

Individual and professional investors buy and sell Individual and professional investors buy and sell stocks under assumption that intrinsic value differs stocks under assumption that intrinsic value differs from market price.from market price.

Perfectly competitive securities market:Perfectly competitive securities market: New information arrives at market independently and New information arrives at market independently and

randomly.randomly. Both buyers and sellers adjust rapidly to new info.Both buyers and sellers adjust rapidly to new info. Current security prices reflect all relevant risk/return info.Current security prices reflect all relevant risk/return info.

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Levels of Market Efficiency

Weak-Form Hypothesis:Weak-Form Hypothesis: current prices reflect all stock current prices reflect all stock market information; trading rules based on past stock market information; trading rules based on past stock market return or volume are futile. market return or volume are futile.

Semistrong-Form Hypothesis:Semistrong-Form Hypothesis: current prices reflect all current prices reflect all public information; trading rules based on public public information; trading rules based on public information are futile.information are futile.

Strong-Form Hypothesis:Strong-Form Hypothesis: current prices reflect all current prices reflect all public information and non-public information. All public information and non-public information. All

trading rules are futiletrading rules are futile..

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Public vs. Private Information

Stock Market Information:Stock Market Information: stock price and stock price and trading volume figurestrading volume figures

Public Information:Public Information: freely shared information freely shared information

Nonpublic Information:Nonpublic Information: proprietary data proprietary data

Insider Information:Insider Information: proprietary information proprietary information within a firmwithin a firm