The chapter discusses the efficient market hypothesis (EMH) which posits that security prices fully reflect all available information. It categorizes the EMH into weak, semi-strong, and strong forms based on the type of information reflected in prices. The implications of EMH for investment and corporate finance are explored. Empirical tests on market efficiency are outlined relating to anomalies in stock returns, market reactions to news, and performance of professional managers. While some evidence supports market efficiency, anomalies exist that may be explained by time-varying risk factors or behavioral biases.

1. Chapter 8
The Efficient Market
Hypothesis

2. Efficient Market Hypothesis
(EMH)
 Do security prices reflect relevant information
fully and immediately?
– What kind of information?
• Past prices, trading volume, etc  Weak form EMH
• Public information announced  Semi-strong EMH
• Private information of managers  Strong EMH
– Competition assures prices to reflect information
• Once information becomes available, market
participants analyze it and trade on it
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3. What are the implications of the EMH?
 Implications for investment
– Will it be possible to beat the market consistently over time?
• In efficient markets, technical trading rules should not work
since all of the past information is contained in current prices
– Empirical evidence is mixed
• Evidence of overreaction or underreaction to information, etc.
 Do stock prices follow random walk?
– Stronger assumption than the EMH
– In fact, EMH allows a submartingale process
• Expected price is increasing over time
• Positive trend and random about the trend
 Implications for corporate finance and business
– Should be difficult to find a project with positive NPVs
3

4. Security Random Walk with Positive Trend
Prices
Time
4

5. Implications for Active or Passive
Management
 Active Management
– Security analysis
• Technical analysis  Market timing
• Fundamental analysis  Stock selection
 Passive Management
– Buy and Hold
– Index Funds
 Empirical evidence
– Investing in passively managed funds such as index fund has
outperformed actively managed funds for the last several
decades.
– What does this imply?
• It is difficult to beat the market consistently over time
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6. EMH and Competition
 Stock prices fully and accurately reflect publicly
available information
 Once information becomes available, market
participants analyze it
 Competition assures prices reflect information
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7. Then, do we need portfolio managers
in an efficient market?
 Even if the market is efficient, there exists a
role for portfolio managers
– Find an optimal portfolio on the efficient frontier
• Two-fund separation theorem
– Maintain appropriate risk level
– Tax considerations
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8. Types of Security Analysis
 Technical Analysis
– Use prices and volume information to predict future prices
– Mainly for market timing purpose
– Related to the weak form efficiency
 Fundamental Analysis
– Use economic and accounting information to predict stock prices
– Mainly for stock selection purpose
– Related to the semi-strong form efficiency
– This includes
• Economic Analysis
• Industry Analysis
• Security Analysis
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9. Empirical Tests of Market
Efficiency
 Weak form efficiency
– Test profitability of some trading rules to see whether past price
or volume contains useful information
 Semi-strong form efficiency
– Perform event studies around important announcements to see
whether public information is reflected immediately
 Strong form efficiency
– Assess performance of professional managers or insiders to see
whether they have superior information unknown to public
investors
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10. How Tests Are Structured
 Examine prices and returns over time
– Serial correlation?
– Seasonality?
– Any predictability?
 Calculate abnormal returns around event windows
– Using the market model, estimate the following:
a. Rt = at + btRmt + et
 Expected Return = at + btRmt
 Excess Return = Actual – Expected return
= (at + btRmt + et) – (at + btRmt) = et
b. Cumulate the excess returns over event windows
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11. Abnormal returns around the Event
-t 0 +t
Announcement Date
Cumulative Abnormal Returns around the Event
-t 0 11 +t

12. Tests of Weak Form EMH
 Returns over short horizons
– Very short horizons (over a couple of weeks)
• Small magnitude of positive trends and reversals
– 3~12 months
• Some evidence of positive momentum
 Returns over long horizons (over 3~5 years)
– Pronounced negative correlation, i.e., reversals
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13. Monthly abnormal returns on
momentum portfolios
 Possible explanations?
– Time-varying risk premium vs. market inefficiency?
– Industry effect?
– Under-reaction to information? (behavioral finance)
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14. Cumulative monthly returns on momentum
 Increase up to one-year after the portfolio formation,
and then, reverse thereafter.
16
14
.
Cumulative monthly returns (%)
12
10
8
6
4
2
0
1 6 11 16 21 26 31 36 41 46 51 56
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Event Months since portfolio formation (6- month/ 6- month momentum strategy)

15. Tests of Semi-strong Form EMH
 Small Firm Effect (January Effect)
 Book-to-Market ratios
 Earnings-to-price ratios
 Cash flow-to-price ratios
 Dividend-to-price ratios
 Post-Earnings Announcement Drift
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16. Size effect (Small firm effect)
 Why does the small firm effect concentrate in
January?
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17. Book-to-market effect
 Value vs. Growth stocks – Value premium?
 Fama-French 3-factor model – MKT, SMB, HML
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18. Post-Earnings Announcement Drift
 Under-reaction to earnings announcements?
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19. Cumulative excess returns around stock split
 Does the stock split add value to the firm?
– Information leakage prior to the event
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20. Tests of Strong Form EMH:
Professional Manager Performance
 Some evidence of persistent positive and
negative performance of mutual funds
 Potential measurement problems
– Performance depends on investment style, e.g.,
momentum, value strategies, etc.
– Could be compensation for risk
 Superstar phenomenon
– Only a small portion survives
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21. Implications of Test Results
 Risk premiums or market inefficiencies
– More relevant question is
“How efficient is the market?”
 True anomalies or data mining
 Behavioral Interpretation
– Inefficiencies exist
– Caused by human behavior
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22. Behavioral Possibilities
 Forecasting Errors
 Overconfidence
 Regret avoidance
 Loss aversion (disposition effect)
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