Emh Hypothesis

Agenda

Efficient capital markets

Efficient market hypothesis

FINC341 Theory of Finance

Impossibility of perfectly efficient markets

Market efficiency and no arbitrage

Efficient Market Hypothesis

Lewis Tam

Motivations

1

Value of Information

One basic assumption of CAPM is that “all investors

analyze securities in the same way and share the same

economic view of the world. The result is identical

estimates of the probability distribution of future cash flows

from investing in the available securities.” (p.264, BKM)

The assumption implies an efficient market in which all

investors are rational, share the same set of information and

interpret the information in the same way.

We all know that such assumption is definitely wrong. But

how far does it deviate from the reality?

Lewis Tam

FINC341 Theory of Finance

FINC341 Theory of Finance

2

Information is relevant (or valuable) only when

1.

2.

it changes the distribution of possible outcomes; and

it changes your optimal course of action as a result of

the change in the distribution of possible outcomes.

Information => more precise forecast => better

decision making => higher utility

Value of information

= The expected utility with the information – the

expected utility without the information

Lewis Tam

FINC341 Theory of Finance

3

Reaction of Stock Price to New Information

in Efficient and Inefficient Markets

Efficient Capital Markets

Stock

Price

Efficient capital markets – the one in which stock

prices immediately and fully reflect available

information (efficient market hypothesis).

There are many investors out there doing research.

As new information comes to market, this information is

analyzed and trades are made based on this information.

Therefore, prices should reflect all available public

information.

Overreaction to “good

news” with reversion

Efficient market

response to “good news”

-30

Lewis Tam

FINC341...