Chapter 6 Are Markets Efficient?

Efficient Market Hypothesis: prices of securities in financial markets fully reflect all available
information.

Example of EMH:
Suppose Microsoft closed with share price of $90 today. However, overnight news came that
they were predicted to reach $120 next year. Equilibrium return rate of Microsoft is 15%. What
does EMH indicate price of Microsoft will be when it opens today?

We know Rof is 15% and Pof is 120. Thus 0.15 = (120-Pt)/Pt. Solving for price today we get
$104. Thus microsoft should open today at $104.

Rationale behind EMH

- In an efficient market, all opportunity for pure arbitrage will be exploited and thus no
profit from arbitrage can be made on the long run
- Assume that the optimal forecast for Exxon stock is 50% over the course of one year,
but the equilibrium return is 10%
- Individuals will continue buying Exxon stock to take advantage of profit and slowly
increase price till optimal forecast equals the equilibrium return
- Strong Version of EMH: securities prices reflects also the intrinsic value of the security
aka Market Fundamentals

Evidence of EMH
- Performance of Investment Analysts and Mutual Funds
- Having performed well in the past does not indicate that an investment manager
will perform well in the future
- It has been shown that investment managers tend to not do better than a
randomly selected portfolio
- This shows that it is incredibly difficult to select winners, proving the EMH
- Stock Prices Tend No to Reflect Publicly Available Information
- Stock prices should reflect all public information
 - It has been shown that stocks typically do not increase that much when good
news is reported
- Random Walk of Stock Prices
- EMH means that stock prices are completely unpredictable
- Stocks move randomly
- Failure of technical analysis

Evidence against EMH

- Small Firm Effect: smaller firms tend to do better than larger firms even though they are
high risk
- January Effect: stock prices tend to rise abnormally higher in January and December,
which counteracts the random walk of stock prices
- Market Overreaction: people tend to overreact and stock prices can drastically change,
related to excessive volatility
- Mean Reversion: Stocks that do well now tend to do more poorly later and vice versa