Efficient Market Hypothesis

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Questions and Answers

What is a necessary condition for all investors to adjust stock valuations in the same way when news arrives?

Rational, professional investors have a great amount of money to invest

All investors receive information in a timely fashion (correct)

Optimists and pessimists have equal influence on markets

Stock prices adjust instantly

According to Shleifer, what is a possible outcome when not all investors are rational?

Irrationality will have no influence on markets

Rational investors will dominate the market

Stock prices will be unfairly priced

The irrationality of optimists and pessimists will balance out (correct)

What is a characteristic of rational investors, according to Shleifer?

They receive information in a delayed fashion

They have a limited amount of money to invest

They process information slowly

They adjust stock valuations in the same way when news arrives (correct)

What is the role of rational, professional investors in the market, according to Shleifer?

They push prices to the 'right' level when they see 'wrong' prices Signup and view all the answers

What is a necessary condition for prices to adjust instantly when news arrives?

All investors receive information in a timely fashion Signup and view all the answers

What is the primary purpose of identifying the information set in the context of market efficiency?

To forecast returns on securities based on available information Signup and view all the answers

According to Roberts (1967), what is the term for the information set that includes all public information?

Semi-strong form efficient Signup and view all the answers

What is the primary challenge in testing the efficiency of a stock market?

The joint hypothesis problem Signup and view all the answers

Which asset pricing model is used to calculate abnormal returns in assessing market efficiency?

CAPM Signup and view all the answers

What is required to assess whether a portfolio generates profits?

Both the returns generated and the risk associated with the portfolio Signup and view all the answers

What is the term for the profits earned due to genuine economic trading opportunities?

Excess returns Signup and view all the answers

What is the implication of an informationally efficient market?

Security prices are unaffected by revealing new information to all participants Signup and view all the answers

What is the condition for a market to be considered efficient with respect to an information set 𝝮?

Security prices would be unaffected by revealing 𝝮 to all participants Signup and view all the answers

What is the implication of Jensen's Definition of Efficiency?

An investor cannot make economic profits by trading on available information Signup and view all the answers

What is the implication of Malkiel's Definition of Efficiency?

A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices Signup and view all the answers

What is the condition for a security to be fairly valued in an efficient market?

The security price reflects all relevant information Signup and view all the answers

What is the implication of the efficient market hypothesis?

It is impossible to tell which securities will deliver returns above or below their required returns Signup and view all the answers

What is the main implication of the joint hypothesis when testing efficiency?

That rejecting the null hypothesis can be due to either or both parts of the hypothesis Signup and view all the answers

Why do increased dividend payments not necessarily lead to predictable returns?

Because stock prices adjust instantly to new information Signup and view all the answers

What do tests of efficiency inherently test?

Both the correctness of the asset pricing model and the informational efficiency of the market Signup and view all the answers

What is the primary observation of researchers using Event Studies techniques?

Markets underreact to the news in earnings announcements. Signup and view all the answers

What is the characteristic of companies that issue shares to the public for the first time?

They tend to underperform the market for up to 5 years. Signup and view all the answers

What is the purpose of autocorrelations in testing efficiency?

To test the proposition that future returns are unrelated to past returns Signup and view all the answers

What do event studies examine?

Price reactions to specific types of corporate or economic events Signup and view all the answers

What is the observation of a momentum strategy in the market?

It delivers positive returns on average. Signup and view all the answers

What is the implication of the existence of momentum in the market?

It is hard to consistently profit from security mispricing. Signup and view all the answers

What is a consequence of rejecting the null hypothesis in efficiency tests?

Uncertainty when interpreting test results Signup and view all the answers

What is the duration of the underperformance of companies that issue shares to the public for the first time?

Up to 5 years. Signup and view all the answers

What is the characteristic of the abnormal returns of portfolios of stocks that have released unexpectedly good earnings news?

They are higher than those of portfolios of stocks that have released unexpectedly bad earnings news. Signup and view all the answers

Study Notes

Stock Valuation and Investor Behavior

All investors adjusting stock valuations similarly requires a shared understanding of information and rational decision-making.
When not all investors are rational, potential market inefficiencies may arise, such as mispricing of assets or a divergence in stock valuations.
Rational investors analyze information systematically, seeking optimal decision-making based on available data.

Role of Rational Investors

Rational, professional investors play a crucial role by correcting mispricings in the market, facilitating efficient price adjustments.
For prices to react instantly to new information, all investors must process this information simultaneously and uniformly.

Market Efficiency and Information

Identifying the information set is pivotal for understanding market efficiency, allowing assessment of how well markets price information.
Roberts (1967) referred to the information set encompassing all public information as the "public information set."
The primary challenge in evaluating stock market efficiency stems from isolating external factors that may influence price movements.

Assessing Market Performance

The Capital Asset Pricing Model (CAPM) is commonly utilized to calculate abnormal returns, vital for gauging market efficiency.
To determine if a portfolio is profitable, performance evaluation against a benchmark is essential.
Profits from genuine economic trading opportunities are termed "informational profits."

Implications of Efficient Markets

An informationally efficient market implies that asset prices reflect all available information accurately at any given time.
For a market to be efficient concerning an information set 𝝮, asset prices must adjust immediately and accurately upon new information release.
Jensen's Definition of Efficiency suggests that markets are efficient if securities consistently reflect available information regarding their value.
In Malkiel's Definition of Efficiency, an efficient market is one where prices follow a random walk, making predictions of future prices virtually impossible.

Fair Valuation and Efficient Market Hypothesis

A security is considered fairly valued in an efficient market when its price equals its intrinsic value, influenced by all available information.
The efficient market hypothesis posits that it is impossible to "beat the market" consistently due to information availability and price adjustments.
The main implication of the joint hypothesis in efficiency testing is that price behavior cannot be distinguished from the validity of the market efficiency theory itself.

Predictability of Returns and Testing

Increased dividend payments do not guarantee predictable returns due to market psychological factors and investor sentiment.
Efficiency tests inherently evaluate the relationship between asset prices and their informational context.
Event Studies techniques primarily observe how stock prices react to specific corporate events or announcements.

Initial Public Offerings (IPOs) and Momentum

Companies going public typically exhibit characteristics such as high initial volatility and investor uncertainty regarding future performance.
Autocorrelations in testing efficiency analyze the potential persistence of returns over time, assessing market predictability.
Event studies focus on determining the impact of significant occurrences on stock prices and trading volume.

Momentum Strategies and Market Consequences

Momentum strategies capitalize on the observed tendency for stocks that have performed well in the past to continue to perform well, and vice versa.
The presence of momentum in the market implies inefficiencies, suggesting that prices do not fully reflect all available information instantaneously.
Rejecting the null hypothesis in efficiency tests indicates evidence favoring market inefficiency and potential trading opportunities.

Underperformance and Earnings Surprises

Companies that issue shares to the public for the first time often experience prolonged underperformance relative to market averages.
Abnormal returns for stocks announcing unexpectedly positive earnings are typically significant, reflecting the market's reassessment of the stock's value.

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Description

Test your understanding of the Efficient Market Hypothesis, including Jensen's and Malkiel's definitions of efficiency. Learn how markets process information and how prices reflect available data.