Thursday, 9 January 2020

Unit 7: Efficient Market Theory

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Unit 7: Efficient Market Theory

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security.

Some of the most interesting and important academic research during the past 20 years has analyzed whether our capital markets are efficient.

Fama divided the overall efficient market hypothesis (EMH) and the empirical tests of the hypothesis into three sub-hypotheses depending on the information set involved: (1) weak-form EMH, (2) semi-strong-form EMH, and (3) strong-form EMH.

In a subsequent review article, Fama again divided the empirical results into three groups but shifted empirical results between the prior categories.

Therefore, the following discussion uses the original categories but organizes the presentation of results using the new categories.

A simple test for strong form efficiency is based upon price changes close to an event.

Acts of nature may move prices, but if private information release does not, then we know that the information is already in the stock price.

An investor can add leverage to the portfolio by borrowing the risk-free asset.

The addition of the risk-free asset allows for a position in the region above the efficient frontier.

Thus, by combining a risk-free asset with risky assets, it is possible to construct portfolios whose risk-return profiles are superior to those on the efficient frontier.

A market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market (with the necessary assumption that these assets are infinitely divisible).

Weak-Form and the Random Walk holds that present stock market prices reflect all known information with respect to past stock prices, trends, and volumes.

Thus it is asserted, such past data cannot be used to predict future stock prices.

Notes Efficient Capital Market: An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security.

Market Portfolio: Market portfolio is a theoretical portfolio in which every available type of asset is included at a level proportional to its market value.

Market Value of an Investment: The market value of an investment is described as its current price on the market.

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