FFENotes15IntroductiontoEMHandValuationModels.doc

Financial Economics Notes 15 Introduction to Efficient Markets Hypothesis and Valuation Models The EMH is the general notion that asset prices in money markets and capital markets are ‘fair’. It is an empirical hypothesis represented by various equivalent statements: current market prices reflect all information available to the market it is impossible to earn excess returns by using information available to the market to guide your trading information is rapidly and accurately disseminated through the market To make sense of the EMH it is necessary to define both information and excess returns. These must be defined in the context of an empirical test. These are generally thought of as being tests of the Fair Game model The Fair Game Model The ‘fair game’ model captures the idea that current information is reflected in current prices. Some notation: is information at time t, is the rational expectation of a return at , given information at time t. The actual return at time is not the expected return. So many textbooks define the fair game as where in an efficient market In an efficient market the observed return at will not on average be different from the return that was expected at time t Another idea (often cited in textbooks) is based on the definition of a return: Re-arrange the equation to find or . Note that this is the same thing as . If the expectation is rational is a fair game and . This formulation is a tautology – the left hand side of the equation simply defines the right-hand side, so nothing has been said. What are people trying to express here? Information in cannot be used to predict deviations of from expected value. It is not possible to use current information to earn an excess return An excess return is an investment return that is persistently greater than . and the Joint Hypothesis Problem To define ‘excess return’ you must have a model of normal expected returns. In the formulation given so far, the conditional expectation condit