Efficient Market Hypothesis
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Market Efficiency and Anomalies
Professor Lasse H. Pedersen
Prof. Lasse H. Pedersen
1
Outline
Versions of the Efficient Market Hypothesis (EMH) Random Walk What makes the market efficient? Problems with testing EMH Evidence in favor of EMH Evidence against EMH: Anomalies
Prof. Lasse H. Pedersen 2
Versions of the Efficient Market Hypothesis (EMH)
Weak-form efficiency:
– prices reflect all information contained in past trading
Semistrong-form efficiency:
– prices reflect all publicly available information
Strong-form efficiency:
– prices reflect all relevant information, including inside information
According to each of these theories, which kind of information cannot be used to trade profitably?
Prof. Lasse H. Pedersen 3
Random Walk
EMH implies that: a stock price is always at the “fair” level (fundamental value) a stock price reacts to news immediately a stock price changes only when the fair level changes therefore, stock price changes are unpredictable because no one knows tomorrow’s news that is, the stock price is a “random walk”:
– tomorrow, the price can go either up or down if the price must go up tomorrow – what would happen today? – the risk-adjusted likelihood of up- and down-movements are equal if the price were extremely likely to go up tomorrow – what would happen today?
Prof. Lasse H. Pedersen 4
What Makes the Market Efficient?
The market is made efficient by supply and demand pressures
– If it is not efficient, investors will trade to take advantage of the inefficiencies
But, if the market is already efficient
– no one will expend resources on security analysis – every investor should just buy a mix of the risk-free security and the market portfolio
Grossman-Stiglitz paradox: How can market be efficient if no one makes security analysis?
– Two economists walk down the street and spot a $20 bill. One starts to pick it up, but the other one says: “don’t bother; if the bill were real, someone would have...
Professor Lasse H. Pedersen
Prof. Lasse H. Pedersen
1
Outline
Versions of the Efficient Market Hypothesis (EMH) Random Walk What makes the market efficient? Problems with testing EMH Evidence in favor of EMH Evidence against EMH: Anomalies
Prof. Lasse H. Pedersen 2
Versions of the Efficient Market Hypothesis (EMH)
Weak-form efficiency:
– prices reflect all information contained in past trading
Semistrong-form efficiency:
– prices reflect all publicly available information
Strong-form efficiency:
– prices reflect all relevant information, including inside information
According to each of these theories, which kind of information cannot be used to trade profitably?
Prof. Lasse H. Pedersen 3
Random Walk
EMH implies that: a stock price is always at the “fair” level (fundamental value) a stock price reacts to news immediately a stock price changes only when the fair level changes therefore, stock price changes are unpredictable because no one knows tomorrow’s news that is, the stock price is a “random walk”:
– tomorrow, the price can go either up or down if the price must go up tomorrow – what would happen today? – the risk-adjusted likelihood of up- and down-movements are equal if the price were extremely likely to go up tomorrow – what would happen today?
Prof. Lasse H. Pedersen 4
What Makes the Market Efficient?
The market is made efficient by supply and demand pressures
– If it is not efficient, investors will trade to take advantage of the inefficiencies
But, if the market is already efficient
– no one will expend resources on security analysis – every investor should just buy a mix of the risk-free security and the market portfolio
Grossman-Stiglitz paradox: How can market be efficient if no one makes security analysis?
– Two economists walk down the street and spot a $20 bill. One starts to pick it up, but the other one says: “don’t bother; if the bill were real, someone would have...