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EFFICIENT MARKET HYPOTHESIS

EMH Assumptions:

Market efciency assumes that a large number of prot maximizing

participants are analysing and valuing securities independent o eachother.

Market efciency assumes that new informationcomes to the market in arandom ashion and that the timing o news announcements areindependent o each other.

Investors adjust their estimate o security prices rapidly to reect theirinterpretation o the new inormation received. However, market efciencydoes not assume that market participants correctly adjust prices, just thattheir price adjustments are uniased. !o, some will over adjust and somewill under adjust. "i.e. errors in market price are random#

The Theory: $n efcient capital market is one where the current price o a security ully

reects all the inormation currently availale aout that security, includingrisk.

$n inormationally efcient capital market is one in which security pricesadjust rapidly to new inormation.

Implication: There is no possibility that we can consistently make an abnormal

return based on the publicly available information. In an efcient market, the e%pected returns rom any investment will e

consistent with the risk o that investment over the long term, though theremay e deviations rom these e%pected returns in the short term.

Note: Market price is an uniased estimate o the true value o the investment &his does not re'uire the market price to e e'ual to true value at every

point in time &his re'uires that the errors in market price e random "uniased#

THREE FORMS OF EMH &he Wea!Form EMH assumes that current stock prices ully reect all

currentlyavailable security market information (historical information).&hus, ino like past price and trading volume will have no relationship with theuture direction o security prices. I the weak orm o the (MH holds, then investors cannot achieve e%cess

returns using technical analysis.

&he Semistrong!Form EMHasserts that security prices adjust rapidly to therelease o all new pulic inormation. &hus current security prices ully reect allmarket and non-market public information. I the semistrong orm o the (MH holds, then investors cannot achieve

e%cess returns using undamental analysis.

&he Strong!Form EMHasserts that stock prices ully reect all inormation rompulic and private sources. &he strong orm includes all types o inormation:market non-market public and private (inside) information. &his meansthat no group o investors has monopolistic access to inormation relevant to theormation o prices.

I the strong orm o the (MH holds, then no group o investors should eale to consistently achieve e%cess returns.

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RO"E OF #ORTFO"$O M%&%'ER I security markets are completely efcient, portolio managers will not e ale

to earn aove)market returns. In this case, the portolio manager has severalresponsiilities. *irst, the portolio manager should seek optimaldi(ersication while minimi+ing transaction costs. !econd, the portoliomanager should help clients understand and 'uantiy theirris tolerances and

return needs. *inally, the portolio manager should monitor bot) t)e clients*needs and circumstancesand changes in the capital markets.

In other words, portolio managers must try to createmaintain a proper mi% oassets to meet their client-s needs. Managers should always ocus on theminimi+ation o transaction costs, ta%es, and li'uidity costs.

&E+ESS%R, +O&-$T$O&S FOR M%R.ET EFF$+$E&+, It is the actions o investors, sensing argains and putting into eect schemes to

eat the market, that make the markets efcient

&he necessary conditions or a market inefciency to e eliminated are:

o &he market inefciency should provide the asis or a scheme to eat the

market and earn e%cess return. *or this to hold:/. the assets"s#, which is the source o inefciency, has to e

traded0. transaction costs o e%ecuting the scheme have to e smaller

than the e%pected pro1ts rom the schemeo &here should e pro1t ma%imising investors who

/. recognise the potential or e%cess return0. can replicate the eat the market scheme that earns e%cess

return2. have resources to trade on the stock until the inefciency

disappearso Internal contradiction

no possiility to eat the market in (M re'uire investors to seek ways to eat the market and thus

make it efcient i markets are efcient, investors will stop looking orinefciencies, leading to markets ecoming inefcient again 3

o !el)correcting mechanism

inefciencies appear at regular intervals ut disappear almostinstantaneously when ound and traded on.

F/RTHER $&TER#RET%T$O& &he e0cient maret )1pot)esis 2EMH3states that:

4securit1 prices full1 re5ect all a(ailable information6

o 4availale to the market pulic4 means that it must e accessile toall

o &his is a very strong hypothesis as it reers to all inormation. It is

thereore very hard easy to reute, as you only need to 1nd onee%ample.

4securit1 prices alwa1s e7ual fundamental (alue6o undamental to the market ut not to insiders

*ormally: ("5t6m

t)/# 7 ("5t6m

t)/, at)/#

where ("5t6m

t)/# 7 inormation set used y the market

("5t6at)/# 7 speci1c inormation placed into the pulic

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domain.

It implies:

- there is no possiility that we can consistentl1 make an anormal

return ased on the pulicly availale inormation.

- i there is inormation put into the pulic domain that has not yet een

used y the market and has not yet een reected into the price, thenthere is an opportunity or investors to make an anormal return

"provided the transaction costs are smaller then the anormal returns#.

!ore "#A info $ materials can be retrieved from the followin%s:

For visitors from Hong Kong: http://normancafe.uhome.net/StudyRoom.htm

For visitors outside Hong Kong: http://www.angelfire.com/nc3/normancafe/StudyRoom.htm

Norman Cheung EMH3

http://normancafe.uhome.net/StudyRoom.htmhttp://www.angelfire.com/nc3/normancafe/StudyRoom.htmhttp://normancafe.uhome.net/StudyRoom.htmhttp://www.angelfire.com/nc3/normancafe/StudyRoom.htm