BEHAVIOURAL FINANCE - SECTION V - CHAPTER 31 - EMH Basics

1. Module - 49
What is Efficient Market
Hypothesis?
CMT LEVEL - I

2. What is Efficient Market Hypothesis?
• The Efficient Market Hypothesis (EMH) essentially says that all known
information about investment securities, such as stocks, is already
factored into the prices of those securities.
• Therefore, assuming this is true, no amount of analysis can give an
investor an edge over other investors, collectively known as "the market.“
• EMH does not require that investors be rational; it says that individual
investors will act randomly, but as a whole, the market is always "right.“
• an unusual reaction to unusual information is normal.
• If a crowd suddenly starts running in one direction, it's normal for you to
run in that direction as well, even if there isn't a rational reason for doing
so.

3. Defining the Forms of EMH
Strong Form
of EMH
Semi Strong
Form of EMH
Weak Form
of EMH

4. What is Efficient Market Hypothesis?

5. What is Efficient Market Hypothesis?
•This form of market holds that current prices of
stocks fully reflect all historical information, thus
past data cannot be used to predict future
prices.
•Tests of the Weak Form
- Serial correlations
- Runs tests
- Filter rules

6. Weak Form of EMH
•This form of market holds that current prices of
stocks fully reflect all historical information, thus
past data cannot be used to predict future
prices.
•Tests of the Weak Form
- Serial correlations
- Runs tests
- Filter rules

7. The Semi Strong Form of EMH
• The semi strong form states that current prices instantaneously
reflect all publicly available information such as quarterly
reports, changes in accounting information, dividends, splits etc.
• Test of Semi Strong Form
- Market Reaction Test
- Earning Impact
- Secondary Offering Impact
- Block Trade Impact
- Bonus Impact

8. The Strong Form of EMH
• The strong form says that prices fully reflect all information,
whether publicly available or not.
• Even the knowledge of material, non-public information
cannot be used to earn superior results.
•Most studies have found that the markets are not efficient in
this sense.
• Test Of Strong Form
- Trading By Stock Exchange Officials.
- Trading By Mutual Fund Managers.

9. Six Lessons for Market Efficiency
•Markets Have No Memory
•Trust Market Prices
• Read The Entrails
• There Are No Financial Illusions
• Do It Yourself Alternative
• Seen One Stock, Seen Them All

10. Random Walk
A random walk is a process where the next step
(flip outcome, in this example) has a fixed
probability that is independent of all previous
flips.
-The mathematical version begins with the idea
that stock prices follow a process known as
random walk.

11. Random Walk
- Suppose you start with $100 in wealth before beginning a
series of coin flips. Suppose further that if you flip a heads,
you receive $1, and if you flip a tails, you have to give up $1.
- After the first flip, for example, you will have either $101 (if
you flip a heads) or $99 (if you flip a tails).Your total wealth
over time, in this simple example, is following a process
known as a random walk.
- If knowing the results of previous coin flips is useful in
predicting future coin flips, then the process is not a random
walk.

12. The Martingale Hypothesis
A martingale is a process whose value at any future date is not
predictable with certainty.
- The best estimate of a future stock price is today's price
(possibly with a risk-adjusted trend over time).
- Instead, they will bound around randomly, but trend upward
in a pattern suggested by the bold solid line. The actual price
movement might appear (or be expected to appear) as the
lighter line that bounces around the solid line
- It is the absence of predictability that is the single most
important feature of the martingale process.

13. The Martingale Hypothesis
Expected Stock Price Actual Stock Price

14. False Evidence against the EMH
• No, clearly such evidence is useless. If coin flipping is completely
random, with a 50 percent chance each time of either flipping heads
or tails, you will still get a significant number of extreme outcomes,
even after repeated trials.
• The same is true of evidence from money management. If money
management outcomes are completely random and no one is really
any good at stock picking, then a small percentage of money
managers will, nevertheless, appear to be good on the basis of their
track records.
• Output from a randomly generated process will typically exhibit
trends, repetition, and other patterns even though the results are
generated by a truly random process.