Efficient Market Hypothesis

Market Efficiency and Anomalies

Professor Lasse H. Pedersen

Prof. Lasse H. Pedersen


Versions of the Efficient Market Hypothesis (EMH) Random Walk What makes the market efficient? Problems with testing EMH Evidence in favor of EMH Evidence against EMH: Anomalies
Prof. Lasse H. Pedersen 2

Versions of the Efficient Market Hypothesis (EMH)
Weak-form efficiency:
– prices reflect all information contained in past trading

Semistrong-form efficiency:
– prices reflect all publicly available information

Strong-form efficiency:
– prices reflect all relevant information, including inside information

According to each of these theories, which kind of information cannot be used to trade profitably?
Prof. Lasse H. Pedersen 3

Random Walk
EMH implies that: a stock price is always at the “fair” level (fundamental value) a stock price reacts to news immediately a stock price changes only when the fair level changes therefore, stock price changes are unpredictable because no one knows tomorrow’s news that is, the stock price is a “random walk”:
– tomorrow, the price can go either up or down if the price must go up tomorrow – what would happen today? – the risk-adjusted likelihood of up- and down-movements are equal if the price were extremely likely to go up tomorrow – what would happen today?
Prof. Lasse H. Pedersen 4

What Makes the Market Efficient?
The market is made efficient by supply and demand pressures
– If it is not efficient, investors will trade to take advantage of the inefficiencies

But, if the market is already efficient
– no one will expend resources on security analysis – every investor should just buy a mix of the risk-free security and the market portfolio

Grossman-Stiglitz paradox: How can market be efficient if no one makes security analysis?
– Two economists walk down the street and spot a $20 bill. One starts to pick it up, but the other one says: “don’t bother; if the bill were real, someone would have...