Topic 5 - Market Efficiency And Behavioural Finance
Explain concept of EMH
EMH states that a market is efficient if:
security prices immediately and fully reflect all available relevant information
the reaction to new information is instantaneous and unbiased
Define the Three forms of EMH
Weak: Stock prices already reflect all past information such as past prices and trading volume. Empirical evidence supports the weak-form.
Semi-Strong: Stock prices already reflect all publicly available information.
Strong: Stock prices already reflects all information, whether publicly available or private held, that is relevant to the firm.
What is the rationale for expecting an efficient capital market. (E.C.M)
A large number of independent, profit-maximising investors engaged in the analysis and valuation of securities.
New information comes to the market in a random fashion; the investorsadjust security prices rapidly to reflect this new information. Thus, independent and randomprice changes.
All information to reflect the "true" current value of stock.
Describe the two sets of tests used to examine the weak-form EMH
Statistical Tests of Independence (S.T.I)
Tests of Trading Rules (T.T.R)
Explain Statistical tests of independence
S.T.I can be divided further into 2 groups: The auto-correlation tests and runs test.
The autocorrelation examines the correlation of price changes on a particular day with a series of consecutive previous days. (i.e. Trading on Thursday than Monday)
The runs tests attempts to determine the pattern of the changes in a series.
What does the EMH imply for the use of Technical Analysis.
The concept of E.C.M contends that there is a rapid dissemination process and prices reflect all information. However, for T.A, the dissemination process is slow - Adjustments of prices is not immediate but forms a pattern.
Thus, no value to T.A because technicians act after the news is made public which would be ineffective in an efficient market.