EFB210 Lecture Notes - Lecture 11: Efficient-Market Hypothesis, Systematic Risk, Abnormal Return
Week 11 Finance 1 Lecture Notes
Market Efficiency
Risk and Return
• What is risk?
o Variaility → Variae → Total Risk
o Total Risk = Systematic Risk + Non-systematic Risk
• Normal Return v Abnormal return
o Beta Risk (systematic risk) - return trade-off
o Normal return: SML
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Efficient Markets Hypothesis: Defined
• If markets are efficient, prices of financial instruments reflect all relevant and
available information such that all investments in such markets are zero NPV
investments (on average).
• For this to be the case:
o An efficient market is a market where prices react to all publicly available
information in an
▪ Instantaneous, and
▪ Unbiased fashion.
• Principles of Corporate Finance, Brealey et al.:
If prices always reflect all relevant information, then they will change only when
new information arrives. But new information by definition cannot be predicted
ahead of time (otherwise it would not be new information). Therefore price changes
cannot be predicted ahead of time. To put it another way, if share prices already
reflect all that is predictable, then share price changes must reflect only the
unpredictable. The series of price changes must be random
• The last aspet radoess of prie hages is what is often (loosely) referred to
as the random walk hypothesis.
Levels of Efficiency
• Weak Form Efficiency reflects past prices
o Test: Can past prices predict future price changes?
• Semi-strong Form Efficiency reflects publicly available information
o Test: Can publicly available information predict future price changes?
• Strong Form Efficiency reflects all information
o Test: Can inside information predict future price changes?
• Predicting future price changes is necessary to achieve consistent abnormal returns.
This statement provides means for assessing the efficient market hypothesis by
examining the performance of
o Technical Traders (use past price information)
o Fundamental Traders (use public information)
o Inside Traders (use inside information)
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