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Summary notes - Efficient Market Hypothesis

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This is a high-level summary of the Efficient Market hypothesis, which forms as part of the Financial Economics and Asset pricing module. This is intended to serve as additional information, complementing the materials offered by the course and recommended research. Be sure to undertake your own pe...

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  • October 13, 2024
  • 3
  • 2020/2021
  • Summary

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Efficient Markets Hypothesis (EMH) – Summary Notes

EMH asserts that prices in the money and capital markets are efficient. Also:

• Current market prices reflect all available information;

• It is not possible to earn excess returns by using information available to the
market to guide trading;

• Information is rapidly and accurately disseminated;

• It is not possible to predict price changes using current information.

Random walks and the EMH

Stock prices should follow a random walk - price changes should be random and
unpredictable.

If prices are determined rationally, only new information will cause them to change.

Irrationality, on the other hand, could be impacted by present or past information

EMH - The idea that stocks already reflect all available information

Grossman & Stiglitz - Investors will have an incentive to spend time and resources to
analyse and uncover new information only if such activity is likely to generate higher
investment returns.

Versions of the EMH

The versions differ by their explanations of what "all available information" is:

1. Weak form - Asserts that stock prices already reflect all information that can
be derived by examining market trading data (e.g. history of prices)

2. Semi-strong - All publicly available information regarding the prospects of a
firm must be reflected already in the stock price Includes all public and past
information

3. Strong form - States that prices reflect all information relevant to the firm,
including private information.

They all suggest that prices should reflect available information

Martingale Model

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