FNCE10002 Lecture Notes - Lecture 11: Efficient-Market Hypothesis, Observational Error, Market Risk
19 Jun 2018
School
Department
Course
Professor
Principles of Finance
Lecture 11: Market Efficiency, Competition and Frictions
11.1 Concept of Capital Market Efficiency
A market is informationally efficient if its prices instantaneously and unbiasedly reflect all the available and
relevant information (Efficient Market Hypothesis EMH).
Instantaneous price reaction- any unexpected news is fully reflected in the price by the time of the
next trade. Unexpected news arrived randomly and can be either good or bad.
Unbiased price reaction- when the market price neither overreacts nor underreacts to new
information in a systematic manner.
Assumes independence, but can be interdependent.
Market Efficiency- Main Assumptions
- There are a large number of profit-maximising participants who are analysing and valuing securities
independently of each other.
- The new information in a market comes in a random manner and timing is independent of other
announcements.
- Market participants adjust their estimates of security prices rapidly to reflect their interpretation of
the new information received.
This does not mean the prices have been correctly adjusted, some participants will over
adjust and others will under adjust. Overall the adjustments to prices will be unbiased.
Market Efficiency- Main Implications
- Securities are priced appropriately according to their market risk.
- Prices of securities reach virtually instantaneously to new information and reach an equilibrium
before investors can exploit the information for abnormal profit or return
Market efficiency implies that abnormal profits or returns cannot be made consistently and after taking
into account all costs associated with gathering and analysing information
11.2 Types of Capital Market Efficiency
Capital markets can be efficient however not all the time and in all cases. There are three forms of market
efficiency considered:
- Weak form
- Semi-strong form
- Strong form
For each type of market efficiency we need to:
1. Define the classification
2. Explain how that type of efficiency may be tested
3. Explain the implications of each type for investment purposes
Weak Form of Market Efficiency
- Information on past prices is fully reflected in current prices.
- Past prices cannot help investors earn returns in excess of what other investors are earning on
similar risk securities. The implication of this is that the best predictor of tomorrows price is the
price today
, where is a random error term
Semi-strong Form of Market Efficiency
- All publicly available information is fully and instantaneously reflected in current market prices.
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Document Summary
A market is informationally efficient if its prices instantaneously and unbiasedly reflect all the available and relevant information (efficient market hypothesis emh). Instantaneous price reaction- any unexpected news is fully reflected in the price by the time of the next trade. Unexpected news arrived randomly and can be either good or bad. Unbiased price reaction- when the market price neither overreacts nor underreacts to new information in a systematic manner. There are a large number of profit-maximising participants who are analysing and valuing securities independently of each other. The new information in a market comes in a random manner and timing is independent of other announcements. Market participants adjust their estimates of security prices rapidly to reflect their interpretation of the new information received. This does not mean the prices have been correctly adjusted, some participants will over adjust and others will under adjust. Overall the adjustments to prices will be unbiased.
