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Chapter 6
Efficient Capital Markets
How do you test the weak-form efficient market
hypothesis (EMH) and what are the results of the tests?
How do you test the semistrong-form EMH and what are
the test results?
How do you test the strong-form EMH and what are the
test results?
For each set of tests, which results support the hypothesis
and which results indicate an anomaly related to the
hypothesis?
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Chapter 6
Efficient Capital Markets
What are the implications of the results for
Technical analysis?
Fundamental analysis?
Portfolio managers with superior analysts?
Portfolio managers with inferior analysts?
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Alternative
Efficient Market Hypotheses (EMH)
Random Walk Hypothesis changes in security
prices occur randomly
Fair Game Model current market price reflect all
available information about a security and the
expected return based upon this price is consistent
with its risk
Efficient Market Hypothesis (EMH) - divided into
three sub-hypotheses depending on the
information set involved
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Weak-Form EMH
Current prices reflect all security-market
information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
This implies that past rates of return and
other market data should have no
relationship with future rates of return
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Semistrong-Form EMH
Current security prices reflect all public
information, including market and nonmarket information
This implies that decisions made on new
information after it is public should not lead
to above-average risk-adjusted profits from
those transactions
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Strong-Form EMH
Stock prices fully reflect all information
from public and private sources
This implies that no group of investors
should be able to consistently derive aboveaverage risk-adjusted rates of return
This assumes perfect markets in which all
information is cost-free and available to
everyone at the same time
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Summary on the
Semistrong-Form EMH
Evidence is mixed
Strong support from numerous event studies
with the exception of exchange listing
studies
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Summary on the
Semistrong-Form EMH
Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
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Summary on the
Semistrong-Form EMH
Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
Dividend yields
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Summary on the
Semistrong-Form EMH
Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
Dividend yields, risk premiums
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Summary on the
Semistrong-Form EMH
Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
Dividend yields, risk premiums, calendar
patterns
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Summary on the
Semistrong-Form EMH
Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
Dividend yields, risk premiums, calendar
patterns, and earnings surprises
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Summary on the
Semistrong-Form EMH
Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
Dividend yields, risk premiums, calendar
patterns, and earnings surprises
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
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Security Analysts
Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
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Security Analysts
Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
This looks at whether, after a stock
selection by an analyst is made known, a
significant abnormal return is available to
those who follow their recommendations
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Security Analysts
There is evidence in favor of existence of
superior analysts who apparently possess
private information
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Performance of
Professional Money Managers
Most tests examine mutual funds
New tests also examine trust departments,
insurance companies, and investment
advisors
Risk-adjusted, after expenses, returns of
mutual funds generally show that most
funds did not match aggregate market
performance
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Behavioral Finance
It is concerned with the analysis of various
psychological traits of individuals and how
these traits affect the manner in which they
act as investors, analysts, and portfolio
managers
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Implications of
Efficient Capital Markets
Overall results indicate the capital markets
are efficient as related to numerous sets of
information
There are substantial instances where the
market fails to rapidly adjust to public
information
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Efficient Markets
and Technical Analysis
Assumptions of technical analysis directly
oppose the notion of efficient markets
Technicians believe that new information is
not immediately available to everyone, but
disseminated from the informed
professional first to the aggressive investing
public and then to the masses
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Efficient Markets
and Technical Analysis
Technicians also believe that investors do
not analyze information and act
immediately - it takes time
Therefore, stock prices move to a new
equilibrium after the release of new
information in a gradual manner, causing
trends in stock price movements that persist
for periods
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Efficient Markets
and Technical Analysis
Technical analysts develop systems to
detect movement to a new equilibrium
(breakout) and trade based on that
Contradicts rapid price adjustments
indicated by the EMH
If the capital market is weak-form efficient,
a trading system that depends on past
trading data can have no value
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Efficient Markets
and Fundamental Analysis
Fundamental analysts believe that there is a
basic intrinsic value for the aggregate stock
market, various industries, or individual
securities and these values depend on
underlying economic factors
Investors should determine the intrinsic
value of an investment at a point in time and
compare it to the market price
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Efficient Markets
and Fundamental Analysis
If you can do a superior job of estimating
intrinsic value you can make superior
market timing decisions and generate
above-average returns
This involves aggregate market analysis,
industry analysis, company analysis, and
portfolio management
Intrinsic value analysis should start with
aggregate market analysis
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Efficient Markets
and Portfolio Management
Portfolio Managers with Superior Analysts
concentrate efforts in mid-cap stocks that do
not receive the attention given by institutional
portfolio managers to the top-tier stocks
the market for these neglected stocks may be
less efficient than the market for large wellknown stocks
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Efficient Markets
and Portfolio Management
Portfolio Managers without Superior
Analysts
Determine and quantify your client's risk
preferences
Construct the appropriate portfolio
Diversify completely on a global basis to
eliminate all unsystematic risk
Maintain the desired risk level by rebalancing
the portfolio whenever necessary
Minimize total transaction costs
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