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Subject: Investment Analysis
Chapter/Topic: Efficient Market Hypothesis
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Concept Definition and Explanation
In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security
Whether markets are efficient has been extensively researched and it is controversial topic in the field of investment analysis and investment management.
Whether markets are efficient has been extensively researched and it is controversial topic in the field of investment analysis and investment management.
The premises of an efficient market - Why markets are efficient with respect to information?
A large number of competing profit-maximizing participants analyze and value securities, each independently of the others.
New information regarding securities comes to the market in a random fashion.
Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information.
Levels of Information and Market Efficiency
Weak-Form EMH - prices reflect all security-market information (used by technical analysis)
Semistrong-form EMH - prices reflect all public information (used by fundamental analysis)
Strong-form EMH - prices reflect all public and private information
Weak-Form EMH
Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return
Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
Strong-Form EMH
Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and available to everyone at the same time
Semistrong-form EMH - prices reflect all public information (used by fundamental analysis)
Strong-form EMH - prices reflect all public and private information
Weak-Form EMH
Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return
Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
Strong-Form EMH
Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and available to everyone at the same time
Tests and Results of Weak-Form EMH
Statistical tests of independence between rates of return
Autocorrelation tests have mixed results
Runs tests indicate randomness in prices
Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all. Filter rules yield above-average profits with small filters, but only before taking into account transactions costs
Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy
Results generally support the weak-form EMH, even though results are not unanimous.
Statistical tests of independence between rates of return
Autocorrelation tests have mixed results
Runs tests indicate randomness in prices
Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all. Filter rules yield above-average profits with small filters, but only before taking into account transactions costs
Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy
Results generally support the weak-form EMH, even though results are not unanimous.
Tests of the Semistrong Form of Market Efficiency
Event studies examine how fast stock prices adjust to specific significant economic events
Cross-sectional returns studies: All securities should have equal risk-adjusted returns
Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns.
Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns.
Evidence is mixed
Strong support from numerous event studies with the exception of exchange listing studies
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient.
Strong support from numerous event studies with the exception of exchange listing studies
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient.
Strong-form EMH contends that stock prices fully reflect all information, both public and private
This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits
The following investor have access to much more information compared to others
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders
These insider trades are made public about six weeks later and allowed to be studied
Corporate insiders generally experience above-average profits especially on purchase transaction
This implies that many insiders had private information from which they derived above-average returns on their company stock.
This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits
The following investor have access to much more information compared to others
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders
These insider trades are made public about six weeks later and allowed to be studied
Corporate insiders generally experience above-average profits especially on purchase transaction
This implies that many insiders had private information from which they derived above-average returns on their company stock.
Specialists have monopolistic access to information about unfilled limit orders
You would expect specialists to derive above-average returns from this information
The data generally supports this expectation
You would expect specialists to derive above-average returns from this information
The data generally supports this expectation
Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not match aggregate market performance.
References:
Reilly, Frank and Keith Brown, Investment Analysis and Portfolio Management, 7th Edition, Thomson-South Western, 2003
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Knols
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Related Knols
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Books
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Research Papers
A Study on Investors' Reaction towards Share Buyback in India
European Journal of Social Sciences, Vol 22, No.2 (2011)
Semistrong form of EMH was tested in this paper
http://www.eurojournals.com/EJSS_22_2_05.pdf
European Journal of Social Sciences, Vol 22, No.2 (2011)
Semistrong form of EMH was tested in this paper
http://www.eurojournals.com/EJSS_22_2_05.pdf
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