...1 EFFICIENT MARKETS HYPOTHESIS Andrew W. Lo To appear in L. Blume and S. Durlauf, The New Palgrave: A Dictionary of Economics, Second Edition, 2007. New York: Palgrave McMillan. The efficient markets hypothesis (EMH) maintains that market prices fully reflect all available information. Developed independently by Paul A. Samuelson and Eugene F. Fama in the 1960s, this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioural economists who argue that the EMH is based on counterfactual assumptions regarding human behaviour, that is, rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioural anomalies. There is an old joke, widely told among economists, about an economist strolling down the street with a companion. They come upon a $100 bill lying on the ground, and as the companion reaches down to pick it up, the economist says, ‘Don’t bother – if it were a genuine $100 bill, someone would have already picked it up’. This humorous example of economic logic gone awry is a fairly accurate rendition of the efficient markets hypothesis (EMH), one of the most hotly contested propositions in all the social sciences. It is disarmingly simple to state, has far-reaching consequences...
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...EFFICIENT MARKETS HYPOTHESIS AND OTHER THEORIES OF PRICING IN FINANCIAL MARKETS Name Course Title/Code Instructor’s Name Date Efficient Markets Hypothesis and other theories of pricing in financial markets Efficient market hypothesis (EMH) is a theory that emerged in the 1960s. It states that it is difficult to predict the market since the price has been set and reflect the current market conditions. It is a disputed and controversial theory. The theory is comparable to other theories of pricing in financial markets. Several strengths and shortcomings emerge through comparison with other theories of pricing (Blinder, et al., 2012). EMH states that no stock is a better buy when compared to others. It is the conclusion that leads to random choices. It is a vital tenet of finance theory. The EMH theory has a basis in other finance theories. It follows the classical theory of asset prices. To determine the connection, a situation where stocks are considered based on good deals. According to the EMH theory, these stocks are worth more than their relative prices. The worth of a stock is the present value of the expected dividends. In this regard, an individual will buy stocks at prices that are below this level. In essence, this is buying stocks that are undervalued assets (Kapil, 2011). Classical theory The classical theory follows the belief that the price of a stock is equal to the best estimate of the stock’s value. This equality means that the undervalued stocks are not real...
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...© 2002 American Accounting Association Accounting Horizons Vol. 16 No. 3 September 2002 pp. 233–243 COMMENTARY The “Incomplete Revelation Hypothesis” and Financial Reporting Robert J. Bloomfield Robert J. Bloomfield is an Associate Professor at Cornell University. INTRODUCTION The most common form of the Efficient Markets Hypothesis (EMH) states that market prices fully reflect all publicly available information (Fama 1970). The EMH has been highly influential among academics, but practitioners and regulators appear unconvinced. Investors work hard to identify mispriced stocks on the basis of public data, or pay others to do so, even though the EMH asserts that such efforts are wasted. Managers seek to boost stock prices by hiding bad news in footnotes, and regulators work hard to defeat such efforts, even though the EMH asserts that information is reflected in prices no matter how obscure its presentation. Beliefs about inefficiency play a central role in the debate over recognizing expenses for incentive stock options. Opponents of expensing argue that the resulting lower net income will inappropriately reduce market prices, while proponents argue the market does not fully recognize compensation costs reported only in footnotes. In efficient markets, however, expensing these costs has no direct effect on prices, as long as the details of the compensation are included in footnotes. The decision to expense option costs could reduce stock price indirectly, even in efficient...
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...an insight into the empirical literature as pertains the evolution of stock market efficiency over time, with a keen focus on the weak form Efficient Market Hypothesis (EMH). The authors provide a systematic review of the correlation between several financial factors namely: Adaptive Markets Hypothesis (AMH), Efficient Markets Hypothesis (EMH), Evolving Return Predictability, Stock markets and Weak-form EMH. The authors pay keen attention on how return predictability from past price changes is affected by key players and determinants on the stock markets. From the survey they conduct, the posit that the bulk of the empirical studies examine whether the stock market under study is or is not weak-form efficient in the absolute sense, assuming that the level of market efficiency remains unchanged throughout the estimation period. The authors acknowledge that one field that has drawn extensive investigation by scholars and other players alike is the predictability of stock returns on the basis of past price changes. This is partly due to its direct implication on weak-form market efficiency. They find that a vast majority of the literature implicitly assumes the level of market efficiency remains unchanged throughout the estimation period. However, the possibility of temporal instability in the underlying economic relations has received increasing attention from economists (see, for example, Stock and Watson, 2003). Kian-Ping Lim and Robert Brooks through their present survey...
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...October 28, 2011 The Efficient-Market Hypothesis and the Financial Crisis Burton G. Malkiel* Abstract The world-wide financial crisis of 2008-2009 has left in its wake severely damaged economies in the United States and Europe. The crisis has also shaken the foundations of modern-day financial theory, which rested on the proposition that our financial markets were basically efficient. Critics have even suggested that the efficient--market–hypotheses (EMH) was in large part, responsible for the crises. This paper argues that the critics of EMH are using a far too restrictive interpretation of what EMH means. EMH does not imply that asset prices are always “correct.” Prices are always wrong, but no one knows for sure if they are too high or too low. EMH does not imply that bubbles in asset prices are impossible nor does it deny that environmental and behavioral factors cannot have profound influences on required rates of return and risk premiums. At its core, EMH implies that arbitrage opportunities for riskless gains do not exist in an *Princeton University. I am indebted to Alan Blinder and to the participants in the Russell Sage Conference on Economic Lessons From the Financial Crisis for extremely helpful comments. 2 efficiently functioning market and if they do appear from time to time that they do not persist. The evidence is clear that this version of EMH is strongly supported by the data. EMH can comfortably coexist with behavior finance, and the insights of Hyman...
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...Summary Roger Lowenstein thought that the current Great Recession could drive a stake through the efficient-market hypothesis (EMH). Analogously, Jeremy Grantham claimed that the incredibly inaccurate efficient market theory cased a lethally dangerous result that led to current plight. However, the EMH is not responsible for the current crisis. Eugene Fama stated that the prices of securities reflect all known information that impacts their value. The hypothesis implies that the prices in the market are mostly wrong, and it is hard to say whether they are too high or too low. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies underestimated the risk in real estate. EMH is not an excuse by the CEOs and regulators of failed financial firms. After the 1982 recession, the U.S. and world economies entered into a long fluctuations period which called the “Great Moderation”. Risk premiums shrank and individuals and firms took on more leverage. Prof. Robert Shiller collected the data which indicates from 1945 through 2006 the maximum cumulative decline in the average price of homes. This low volatility might lead to the mortgage security composed of a nationally diversified portfolio of loans would have never come close to defaulting. These models led credit agencies to rate these subprime mortgages as “investment grade”. But this assessment was faulty. In fact, never before have home prices jumped that far...
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...OF INVESTMENT AND PORTFOLIO ANALYSIS Efficient Market Hypothesis (EMH) SUBMITTED TO DR. NIAMAT KHAN SUBMITTED BY SSH SHAYKH ROLL NO: 04 INSTITUTE OF MANAGEMENT STUDY UNIVERSITY OF PESHAWAR Efficient Market Hypothesis (EMH) Has been consented as one of the cornerstones of modern financial economics. Fama first defined the term "efficient market" in financial literature in 1965 as one in which security prices fully reflect all available information. The market is efficient if the reaction of market prices to new information should be immediate and impartial. Efficient market hypothesis is the initiative that information is quickly, and efficiently integrated into asset prices at any position in time, so that old information cannot be used to foretell future price movements. Therefore, three versions of EMH are being notable depends on the level of available information. TYPES OF Efficient Market Hypothesis (EMH) Weak form EMH The current asset prices already imitate past price and volume information. The information enclosed in the past succession of prices of a security is completely reflected in the current market price of that security. It is named weak form because the security prices are the most publicly and easily available pieces of information. It implies that no one should be able to smash the market using something that "everybody else knows". Yet, there are still numbers of financial researchers who are studying the past stock price cycle and trading...
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...1. Explain what efficient market hypothesis is. ` In a simple statement, the Efficient Market Hypothesis (EMH) means that security prices fully reflect all available information (Fama, 1991). There are three forms of EMH. Weak Form EMH Semi-Strong Form EMH Strong Form EMH • All past prices of a stock are reflected in today's stock price. • Technical analysis cannot be used to predict and beat a market. • All public information is calculated into a stock's current share price. • Neither fundamental nor technical analysis can be used to achieve superior gains. • All information in a market, whether public or private, is accounted for in a stock price. • Not even insider information could give an investor the advantage. Adapted from http://www.investopedia.com/exam-guide/cfa-level-1/securities-markets/weak-semistrong-strong-emh-efficient-market-hypothesis.asp#axzz27eAhlXfl The assumptions behind this hypothesis are; 1. A large number of profit-maximising participants analyse and value securities independently. 2. News regarding securities comes to the market randomly and independently. 3. Trading decisions of all the investors adjust security prices rapidly to reflect the effect of new information. . 2. Link it to the idea of the fully revealing rational expectations equilibria. The EMH is the application of Rational Expectations Theory by Muth (1961). Assuming there is only one equilibrium price, it states that outcomes do not differ systematically from what...
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...Essay Plan * How Financial Markets function normally? EMH and its alternatives - EMH alternatives - Option-pricing models, risk-weighted portfolio, index funds, derivatives, securitised mortgages that are supposed to spread and reduce risks. Free Market Theory, capitalism. * The last four years have seen radical changes in how financial markets operate. Since the economic crash, how have the Financial Markets changed how they function? Nationalization of banks (bailouts); G20 conference financial packages on offer; BRIC countries wanting more say/power in the global order; Quantitative Easing and LTRO (European Sustainability Fund, Troika) in Western banking. * Can this new financial system be sustained when it is so heavily dependent on Central Banking bailouts? * Hedge Funds – why is money flowing so easily into more risky hedge funds? Hedge funds are the child of volatility BAC 5014 - Investment Markets & Principles Commentators have argued that the glut of Central Bank money is underpinning the markets in a way that takes away any pretence of “efficiency” and far away from normal liquidity constraints. a) To what extent do you agree and why? b) Within this new framework Hedge Funds continue to attract new sources of finance- evaluate why might this be? How Financial Markets function normally? Financial Markets are all about the raising of capital and the matching of those who want capital, borrowers, and those who have capital, lenders...
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...prices of eminent market indices from a time period 2004-2013.The stock returns have been subjected to unit root tests such as the Augmented Dickey Fuller test and a panel unit root test. Additionally the existence of random walk for these stock markets has also been examined through the Jarque-Bera statistic. The results indicate information inefficiency in the time period under study for all indices. Investors can therefore predict future prices on the basis of historical information, and receive excessive returns. The results have implications for developing economies wherein the government has to ensure that all asset related information be made public, to curb state interference. Introduction The concept of Efficient Market Hypothesis (EMH) holds special importance in the field of Finance, especially Capital markets. This hypothesis postulates that markets are informationally efficient. This asserts that the price of any security will fully reflect all the information that is available to the investors. That being said, one cannot consistently achieve returns that are excess of the average market returns on a risk-adjusted basis, with information available at the time of investment. First developed separately by Eugene F. Fama and Paul A. Samuelson, the concept assumes that the investors need not be rational. In an efficient market, investors may either overreact or under react to newly available information. The investor’s reactions are random, such that the price changes are...
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...momentum. In the longer-run there is reversal as prices revert to fundamentals. Other behavior biases and empirical challenges First of all, it is impractical to claim that people in general and investors in particular are fully rational. Several biases contribute to the irrationality. Loss aversion People don’t look at the levels of final wealth they can attain but at gains and losses relative to some reference points. They tend to avoid actions that could create discomfort over prior decisions, even though those actions may be in the individual’s best interest. Researchers have showed evidence of investors’ reluctance to sell losing positions. Representativeness Individuals placed too much weight on a small number of recent events. In financial markets, investors make systematic errors in assessing the probability of uncertain events. It is found that value stocks actually outperformed glamour stocks by about 8.7% per annum possibly because most investors pursue naïve strategies by extrapolating trends, overreacting and...
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...In finance, the efficient-market hypothesis (EMH), or the joint hypothesis problem, asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". The weak form of the EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong form of the EMH additionally claims that prices instantly reflect even hidden or "insider" information. Critics have blamed the belief in rational markets for much of the late-2000s financial crisis.[1][2][3] In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals.[4] In political science and economics, the principal–agent problem or agency dilemma concerns the difficulties in motivating one party (the "agent"), to act in the best interests of another (the "principal") rather than...
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...Efficient portfolio & Stock market efficiency Prepared by: Ahmed Mohamed Ahmed Zaki Nofal Submitted to: Dr.Tarek el Domiaty Modern portfolio theory Modern portfolio theory (MPT) is a theory of finance which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize[1] for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed, even if they are positively correlated More technically, MPT models an asset's return as a normally distributed function (or more generally as an elliptically distributed random...
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...the hypothesis. It also examines the theoretical role and motivation of analysts in creating market efficiency; lastly it looks at alternative perspectives on the pricing of securities. Introduction In 1984 Warren Buffett penned an article titled “The Superinvestors of Graham-and-Doddsville”, based on a speech he had given on the occasion of the 50th anniversary of his mentor Ben Graham’s legendary textbook, Security Analysis. In it, Buffett rejected the then growing (and now entrenched) view in academia that markets are ''efficient'' because ''stock prices reflect everything that is known about a company’s prospects and about the state of the economy.'' Warren Buffett argued against EMH, saying the preponderance of value investors among the world's best money managers rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others. (Hoffman, 2010) This report will either agree with Buffet or somewhat sit on the fence. A market is said to be efficient with respect to an information set if the price ‘fully reflects’ that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set...
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...Financial Market Definition of 'Financial Market' Broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees and market forces determining the prices of securities that trade. Some financial markets only allow participants that meet certain criteria, which can be based on factors like the amount of money held, the investor's geographical location, knowledge of the markets or the profession of the participant. Investopedia explains 'Financial Market' Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others – like the New York Stock Exchange (NYSE) and the forex markets – trade trillions of dollars daily. Most financial markets have periods of heavy trading and demand for securities; in these periods, prices may rise above historical norms. The converse is also true – downturns may cause prices to fall past levels of intrinsic value, based on low levels of demand or other macroeconomic forces like tax rates, national production or employment levels. Information transparency is important to increase the confidence of participants and therefore foster an efficient financial marketplace. Financial Markets: Capital Vs. Money Markets ...
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