EMH

Introduction about EMH

A market in which prices always fully reflect all available information is called efficient”.

Notice that the level/degree/form of efficiency in a market depends on two dimensions:

1. The type of information incorporated into price (which information is “available”?).

2. The speed with which new information is incorporated into price ( how fast information is

“reflected”?).

Foundations of EMH

• There is an intrinsic value of financial assets

• The huge army of traders keep prices near that intrinsic value

• Information shall be absorbed immediately ▫

(a) If there is a lag (delay) in absorption, that will be random 

(b) Sometimes before the news, sometimes after the news

• No Arbitrage Opportunity: ▫

• Price change will be subject to flow of new information which was not earlier anticipated

• Joint Hypothesis :

▫• As information absorption and its efficiency can be determined only with reference to equilibrium pricing ▫

• A test of efficiency will always be a joint test of  Market Efficiency  Pricing Model [CAPM, APT etc] ▫ So one can never be sure which one to blame

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Forms of EMH –Fama (1970)

Market Prices Reflect

A. Weak-Form Efficiency / Lack of Predictability

1. Price reflects all information contained in market trading data

(past prices, volume, dividends, interest rates, etc.).

2. So an investor can not use past prices to identify mispriced

securities.

3. Technical analysis:

(1) Refers to the practice of using past patterns in stock prices

(and trades) to identify future patterns in prices.

(2) Is not profitable in a market which is at least weak form

(i.e., weakly) efficient.

B. Semi-Strong Form / “Events” Reflected Immediately

1. Price reflects all publicly available information.

2. So an investor can not use publicly available information to

identify mispriced securities.

3. Fundamental analysis:

(1) Refers to the practice of using financial statements,

announcements, and other publicly available information

about firms to pick stocks.

(2) Is not profitable in a market which is at least semi-strong

form (i.e., semi-strongly) efficient.

4. If a market is semi-strong form efficient, then it is also weak form efficient since past prices and other past trading data are publicly available.

C. Strong-Form / All Private Information is Reflected

Price reflects all available information.

If a market is strong form efficient, then it is also semi-strong and weak form efficient since all available information includes past prices and publicly available information.

Implications of EMH

• Deviation from value is not ruled out, however Equal chance that prices will over-valued or under-valued ▫ For instance, stocks with lower PE ratios should be no more or less likely to be under valued than stocks with high PE ratios. ▫ As a result, no investor shall be consistently able to find under-valued stock

•No investor or group of investors should be able to consistently outperform the market

KNOWLEDGE CHECK:

If a skilled fundamental financial analyst and an insider trader all earn the same long-run risk-adjusted returns, what form of market efficiency is likely to apply?

A. Weak form

B. Semi-strong form

C. Strong form