Efficient Market Hypothesis

Efficient Market Hypothesis

• The rate of return is calculated by adding the capital gain (or loss) to the dividend, then dividing by the initial price.
• The unknown element in rate of return calculations is the future price (Pt+1) at the start of period t.
• Expectations are equivalent to optimal forecasts in this context.
• Expected return on a security will equal the optimal forecast of the return.
• An optimal forecast represents the best possible guess about the future, utilizing all available information but does not guarantee perfect accuracy.

Efficient Market Hypothesis Continued

• Real-world financial markets cannot be fully understood with the expected price of a security one period into the future (P_{t+1}) or the expected rate of return (R^e) being directly observable.
• The expected return on a bond tends to move toward the equilibrium return, relating to the supply-and-demand framework.
• Current prices in financial markets reflect optimal forecasts of a security’s return, using all available data which equals the security’s equilibrium return.
• In an efficient market, a security’s price fully incorporates all available information.
• No new, valuable data can sway prices because they already reflect all available information within an efficient market.

Efficient Market Hypothesis Example

• If Microsoft stock closed at $90, news emerges for a $120 target the next year, and the equilibrium return is 15%, under EMH, the price will go to $104.35 when the market opens.

Arbitrage and Efficient Market Hypothesis

• An unexploited profit opportunity prompts immediate buying until returns normalize, this is called arbitrage.
• In the presence of an unexpected profit opportunity (R°f > R*), demand increases, pushing the current price up which then decreases the expected return (continues until R°f = R* where the profit opportunity is gone).
• If the security in question is a poor investment (Rof < R*), its price falls, increasing the return until Rof = R*, satisfying the efficient market condition.

Arbitrage and Efficient Market Hypothesis Continued

• Arbitrage leads to the elimination of unexploited profit opportunities within efficient markets.
• Not all investors need awareness of every security, but a few with "smart money" seeking unexploited profits are needed.
• Efficient market conditions persist even with uninformed participants.
• Financial markets accommodate many participants, but only a fraction needs to be "smart" to uphold EMH.

Three Versions of the EMH

• Weak-form efficiency means stock price shifts are independent of past data, and historical pricing data is already reflected in the current price.
• Semi-strong form efficiency means all publicly available information is reflected in a share's price.
• Strong-form efficiency means not only optimal expectations but insider insights characterize an efficient market.
• Empirical data supports both weak and semi-strong versions of market efficiency.

Testing the EMH

• The EMH is tested if consistent with random walk processes, and is therefore unpredictable.
• Random walk without drift is expressed as Yt = Yt-1 + ut.
• Random walk with drift is expressed as Yt = δ + Yt-1 + ut.
• Yt and Yt-1 represent stock prices at time t and t-1.
• ut is a white noise error term, possessing a zero mean and variance σ².
• Scope for profitable speculation is removed as stock prices become random.

Evidence in Favor of the EMH

• Investment analysts and mutual funds do not consistently beat the market.
• Stock prices adhere to random walk processes.
• Technical analysis consistently fails to outperform the market.
• Stock prices reflect readily available public data, such as Earning reports.

Evidence Against the EMH

• Small firm and January effects indicate deviations from EMH.
• Market overreaction and excessive volatility challenge EMH.
• Mean reversion, where low returns are followed by high returns and vice-versa, contradicts random walk models.
• New information incorporation into stock prices is not always immediate.

Summary and Implications

• Investment advisors' published reports may be unreliable as hot tips quickly vanish.
• Scrutiny of hot tips is needed under EMH, as the market erases them soon after launch.
• Equilibrium return is the only possible return as prices reflect already available data.

Summary and Implications Continued

• Stock prices respond only to new, unexpected announcements.
• No stock price response exist for projected good news.
• Stock prices shift if the news is unexpected.

Summary and Implications Continued

• Investors should not second-guess markets via constant trading.
• Buy and hold strategy of stock investment is better for returns over brokerage costs.
• Investing in mutual funds is more cost-effective because of portfolio costs.

Summary and Implications Continued

• The Efficient Market Hypothesis is simply a hypothesis and does not imply markets are truly efficient at all times.
• bubbles or market crashes happen if the asset prices dont match the fair prices.
• Due to these limitations more work is being put into behavioral finance.