The Efficient Market Hypothesis Efficient Market Hypothesis EMH

The Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) • Do security prices reflect information ? • Why look at market efficiency – Implications for business and corporate finance – Implications for investment Irwin/Mc. Graw-Hill 9 -2 ©The Mc. Graw-Hill Companies, Inc. , 1998

Forms of the EMH • Weak • Semi-strong • Strong Irwin/Mc. Graw-Hill 9 -3 ©The Mc. Graw-Hill Companies, Inc. , 1998

Types of Stock Analysis • Technical Analysis - using prices and volume • information to predict future prices – Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices – Semi strong form efficiency & fundamental analysis Irwin/Mc. Graw-Hill 9 -4 ©The Mc. Graw-Hill Companies, Inc. , 1998

Random Walk Hypothesis • Why are price changes random? – Prices react to information – Flow of information is random – Therefore, price changes are random Irwin/Mc. Graw-Hill 9 -5 ©The Mc. Graw-Hill Companies, Inc. , 1998

Security Prices Irwin/Mc. Graw-Hill Random Walk with Positive Trend 9 -4 Time ©The Mc. Graw-Hill Companies, Inc. , 1998

Empirical Tests of Market Efficiency • Event studies • Assessing performance of professional • managers Testing some trading rule Irwin/Mc. Graw-Hill 9 -7 ©The Mc. Graw-Hill Companies, Inc. , 1998

Returns Over Time -t 0 +t Announcement Date Irwin/Mc. Graw-Hill 9 -13 ©The Mc. Graw-Hill Companies, Inc. , 1998

What Does the Evidence Show? • Technical Analysis • Fundamental Analysis • Anomalies Exist Irwin/Mc. Graw-Hill 9 -9 ©The Mc. Graw-Hill Companies, Inc. , 1998

Anomalies • • Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Value Line Enigma Post-Earnings Announcement Drift Higher Level Correlation in Security Prices Irwin/Mc. Graw-Hill 9 -10 ©The Mc. Graw-Hill Companies, Inc. , 1998

Mutual Fund and Professional Manager Performance • Some evidence of persistent • • positive and negative performance Potential measurement error for benchmark returns – Style changes – May be risk premiums Superstar phenomenon Irwin/Mc. Graw-Hill 9 -11 ©The Mc. Graw-Hill Companies, Inc. , 1998

Implications of Efficiency for Active or Passive Management • Active Management – Security analysis – Timing • Passive Management – Buy and Hold – Index Funds Irwin/Mc. Graw-Hill 9 -12 ©The Mc. Graw-Hill Companies, Inc. , 1998

Market Efficiency and Portfolio Management Even if the market is efficient a role exists for portfolio management – Appropriate risk level – Tax considerations – Other considerations Irwin/Mc. Graw-Hill 9 -13 ©The Mc. Graw-Hill Companies, Inc. , 1998