The Efficient Market Hypothesis

The Efficient Market Hypothesis


CHAPTER 11 BKM 8TH ED.

The Efficient Market Hypothesis
Slides: BKM, Alex Kane and self

Main objectives
2

Understand the concept of market efficiency Understand how to make rational investment decisions based upon the existence of market efficiency Understand the many tests of market efficiency, the forms of market efficiency and observed marketanomalies.

Market Efficiency
3

The Efficient Market Hypothesis (EMH) states that prices reflect all information, hence active strategies are not superior to the passive “buy and hold”. Market efficiency is a central concept in finance Moreover, this is a concept that occupies the minds of non-finance people more than any other concept in finance Why? Because everyone has a stake in whethereasy, perhaps “unfair”, abnormal profits can be made from speculation in capital markets (most people instinctively know that such potential has enormous value)

The Stakes in Market Efficiency
4

Most people mistakenly think that the crux of the matter is distributive-justice: who will garner the huge potential profits from inefficiency? But it is the even greater value of efficient resourceallocation, which in a capitalistic system is incalculably vast. This is since capital-market prices determine resource allocation. Therefore,
Information-inefficient prices would lead to inefficient resource allocation -- a huge social cost Central-planning economies are deficient on two counts: (1) lack of incentives and (2) resource misallocation. Notice that efficient prices also affectefficient incentives

Are Prices of Capital Assets Rational?
5

Valuation of an asset sets its intrinsic value, P*, as (1) P*=PV (future CF) the best available CF forecast discounted at the appropriate rate Question: Are actual prices, P, equal to intrinsic values: (2) P = P* ?? Conventional wisdom used to be: Prices are driven by “animal spirits” (or sunspots) and hence equation (2) does notgenerally hold Keynes suggested prices are set as in a beauty contest: Judges are interested in what others think is beautiful High volatility is taken as sign that prices are unrelated to fundamentals (fundamentals appear far less volatile: div vs. Px)

The Kendall Story (1953)
6

Time Series Analysis essentially decomposes changes in a time series to
Trend; Seasonality; Cycles; IrregularityIdentification of the first three components makes for better forecasting accuracy

Kendall was asked to present a seminar on modeling techniques. He thought demonstration with speculative prices would be interesting Indeed! To his surprise, he found the first three components vanished, leaving only irregularity. Result: no predictability

Random Walk (RW)
7

If a time series ofobservations on a variable has no trend, seasonality or cycle, it is a RW If there is a trend, but no seasonality and cycle, it is a RW with a “drift” -- no predictability of deviations from the trend. Although prices of many risky assets must have a drift, or else none will hold them, over very short trading horizons (say daily), the drift will be negligible Representation of RW: E(Pt+h)=Pt for all t andh.

Debate Over Kendall’s Finding
8

Kendall’s finding sparked a debate One camp interpreted the results as proof that capital asset prices are irrational Others advanced a new idea: The very fact that prices are unpredictable is proof of rationality
If change in an asset’s price is predictable, rational investors would trade to take advantage. These trades would only cease when furtherchanges (other than required drift) are unpredictable

Samuelson’s Theorem
9

Well anticipated prices fluctuate randomly Samuelson used to quip that on odd days he feels this is his greatest theorem; on even days he feels it’s just a tautology The theorem implies a sufficient condition:
If a price is rational => it will fluctuate randomly

But, what about the implication: If a price...