Efficient Market Theory

Efficient Market Hypothesis (EMH)

1. Eugene Fama in in the paper “Efficient Capital Markets: A Review of Theory and Empirical Work,” (1970) synthesized earlier works and presented a comprehensive framework that outlined the concept of market efficiency.
2. Fama’s contribution to understanding how securities prices reflect available information earned him the Nobel Prize in Economic Sciences in 2013.

Contribution to the theory and practice

1. Stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
2. There is no practical chance to outperform the market systematically.
3. Application of the Technical nor Fundamental analysis in pointless.
4. Passive investing in the low-cost ETFs is recommended.

Three form of the efficiency - Weak form

All past prices of a stock are reflected in today’s stock price. Therefore, technical analysis cannot be used to predict and beat the market.

Test 1. Serial Correlation Tests: These tests check for correlations between sequential price changes. If prices are truly random (following a random walk), there should be little to no correlation between past and future price changes. \[H_0: \rho(p_t, p_{t-i}) = 1 \quad \text{vs.} \quad H_1: \rho(p_t, p_{t-i}) \neq 1\] 2. Non-parametric Runs test

Model

Three form of the efficiency - Semi-strong form

All public (but not non-public) information is calculated into a stock’s current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.

Test Event Studies: These studies examine the stock price reaction to new public information, such as earnings announcements, to determine how quickly and accurately prices adjust.

The abnormal return

is the actual ] is the expected return based on a model (e.g., the market model).

Model

Three form of the efficiency - Strong form

All information in a market, whether public or private, is accounted for in a stock’s price.

Test

Model

Random Walk

Random walk model serves as the test for the weak form of the EMH. The model has a form \[P_t = P_{t-1} + \epsilon_t\] where \(\epsilon_t\) is a random error term (or shock) at time \(t\) that is independently and identically distributed (i.i.d.) with a mean of zero.

Martingale model

Serves as a test for the semi-strong (or strong) form of EMH

\[P_t = E[P_{t+1}/\mathcal{F}_{t}]\]

where \(E[P_{t+1}/\mathcal{F}_{t}]\) is the conditional expectation of the price at time \(t+1\) based on the available information \(\mathcal{F}_t\) in time \(t\).