RSM332 - Week #11
An efficient market condition in which transaction costs are low.
An efficient market condition in which there are enough securities to efficiency allocate risk.
An efficient market condition in which important information is reflected in share prices.
That is, material facts are publicly disclosed and investors use all publicly available information in their
A market that reacts quickly and relatively accurately to new public information, which results in prices
that are correct (fairly valued) on average. True market efficiency is not practical in real life because it
requires instantaneous and perfect price adjustments.
Assumptions of an efficient market
1. There are a large number of rational, profit-maximizing investors who actively analyze, value,
and trade securities. The markets are perfectly competitive (price takers).
2. Information is costless and widely available at the same time.
3. Information arrives randomly (announcements are not expected or related to one another).
4. Investors react quickly and fully to new information (reflected in stock prices).
Securities analysts whose job it is to monitor companies and regularly report on their value through
earnings forecasts and buy/sell/hold recommendations; they work for investment banks that underwrite
and sell securities to the public.
Securities analysts whose job it is to evaluate the research and recommendations produced by the sell-side
analysts; they work for institutions in the capital market that invest in securities.
Implications of market efficiency
1. Technical analysis is not likely to be rewarded by consistent abnormal returns. This is because
markets appear to be, at minimum, weak form efficient.
2. Fundamental analysis is not likely to be rewarded by consistent abnormal returns, although some
opportunities are available. This is because one’s analysis would have to be consistently superior
to earn higher returns. In reality, average, or below-average, analysis consistently results in
3. Active trading strategies are not likely to outperform passive strategies on a consistent basis. Efficient market hypothesis (EMH)
The theory that markets are efficient and, therefore, that prices accurately reflect all available information
at any given time.
Weak form EMH
Security prices full reflect all market data, which refers to all past price and volume trading information.
All past data is already reflected in current prices and is of no value in predicting future price changes.
Weak form evidence
Tested by finding empirical evidence for the independence of price changes.
serial correlation tests: correlation between price changes for various lags (a day, a month, etc.)
runs (signs) tests: classify each price change by +/0/- and examine if they are any patterns
these tests do tend to suggest that price changes are independent of one another
If any trading rule that attempts to exploit historical trading data is able to consistently generate abnormal
risk-adjusted returns after trading costs, then weak form efficiency would be contradicted:
technical analysts (chartists) believe this is possible
evidence suggests that technical trading rules do not consistently produce abnormal returns
evidence of long-term “reversal” patterns in stock returns
people tend to overreact to new information allowing contrarian strategies to work
recent three- to five-year “losers” tend to outperform in the future
recent three- to five-year “winners” tend to underperform in the future
evidence of short-term momentum patterns in stock returns
stocks with high 3- to 12-month returns tend to outperform in the following months
this is the opposite of the long-term reversal pattern
evidence of seasonal patterns in stock returns
stock returns are statically higher