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• A market is efficient if prices “fully ______________” available information and adjust rapidly to new information.

• “Fully reflect” means that set of information cannot be used to benefit investors.

Ch 8: The Efficient Market Hypothesis (EMH)

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• Market prices are determined by the actions of buyers and sellers.

• In an efficient market, security prices fairly reflect all that is ____________________________

Market Efficiency

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• An efficient market is a “fair game” if information is equally available. Public info cannot be used to “beat the market.”

• “Beat the market:” earn above market (abnormal) returns after deducting transaction _________ and adjusting for ___________

Market Efficiency

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• Random: without definite aim, direction, rule or method. If something is random, it cannot be explained or predicted.

• If a market is efficient, prices are ______ random; price _________ are random.

Random Walk and the EMH

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• The Random Walk Hypothesis of stock prices:• Expected price change is

____________________• Positive trend and random about

the trend

Random Walk and the EMH

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Security Security PricesPrices

TimeTime

Random Walk with Positive TrendRandom Walk with Positive Trend

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• Why would price changes be random?• Prices react to information• Flow of information is _________• Therefore, price changes are

random

Random Price Changes

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• The law of one price states that different prices for the same item cannot persist (unless explained by transaction costs).

• If prices differences exist, ________________________ will quickly eliminate the difference.

Law of One Price

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• Arbitrage: simultaneously ________ and __________ at different prices, locking in risk-free profits with no capital outlay.

• Arbitrage opportunities are uncommon and short-lived in an efficient market.

Arbitrage

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Forms of the EMH• ________________________ form• ________________________ form• ________________________ form

• These vary with respect to the set of information

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Weak Form of EMH• A market is weak-form efficient if

prices fully reflect all ______________________ data.

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Weak Form of EMH• Market data includes:

• past and current ________________• ___________________• ___________________ interest• ___________________ transactions.

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Weak Form of EMH• The _________________________

holds if a market is weak-form efficient: arbitrage opportunities are nonexistent or transitory.

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Weak Form of EMH• _____________________Analysis:

using patterns in market information (prices and volume) to predict prices

• If the stock market is weak-form efficient, can technical analysis benefit investors?

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Semistrong Form EMH• A market is semistrong efficient if prices

fully reflect all ____________________ information

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Semistrong Form EMH• Fundamental Analysis - using

__________________________ and accounting information to predict prices

• If the stock market is semistrong form efficient, can fundamental analysis benefit investors?

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Strong Form EMH• A market is strong form efficient if

prices fully reflect ______________ information, public and private.

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Strong Form EMH• If the stock market is strong form

efficient, do insiders have an advantage over other investors?

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• If you believe markets are efficient:• _____________________ broadly

(including internationally)• Match portfolio risk to your risk

tolerance• Buy & Hold to minimize ___________

and transaction costs

Investment Strategy in Efficient Market

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If you believe markets are inefficient, you can try to beat the market by identifying ___________________ sectors or securities and overweighting (fundamental analysis) or by using technical analysis.

Inefficient Market Investment Strategy

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• The evidence is generally consistent with weak form efficiency in securities markets. Most studies conclude that technical analysis is not profitable. Not all evidence is consistent with weak form efficiency, however.

Tests of Weak Form Efficiency

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Tests of Weak Form (Cont.)• Stock prices exhibit short-run

_________________ and long-run ______________________.

• Neither tendency is very strong, but both are potentially inconsistent with weak-from efficiency.

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Tests of Semistrong Efficiency

• The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information.

• Several price patterns are inconsistent with semistrong efficiency, however (“_______________________”).

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• An “anomaly” is something that deviates from what is believed to be true.

Tests of Semi-strong Form: Anomalies

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• ______________ Firm / January Effect

• Neglected Firm• Market to _______________ Ratios• Post-Earnings Announcement Drift

Tests of Semi-strong Form: Anomalies

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Implications of Test Results

• Risk Premiums or market inefficiencies?

• Anomalies or data mining?• Behavioral Interpretations:

inefficiencies might be the result of investors’ irrationality in systematic ways.

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Mutual Fund and Professional Manager

Performance• Some evidence of persistent

positive and negative performance• Superstar phenomenon: financial

markets might be efficient for most, but not all participants.