Homework Chapter 6

1. Explain what is the efficient Market Hypothesis.

- is an investment theory that states it is impossible to "beat the

market" because stock market efficiency causes existing share
prices to always incorporate and reflect all relevant information.
According to the EMH, stocks always trade at their fair value on
stock exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices. As
such, it should be impossible to outperform the overall market
through expert stock selection or market timing, and the only way
an investor can possibly obtain higher returns is by purchasing
riskier investments.

2. Justification and rationale behind the Hypothesis.

-When an unexploited profit opportunity arises on a security,

investor will rush to buy until the price rise to the point that the
returns are normal again.
-In an efficient market, all unexploited profit opportunities will be
eliminated.
-Not every investor need be aware of every security and situation.
As long as a few keep their eyes open for unexploited profit
opportunities, they will eliminate the profit opportunities that appear
because in so doing, they make a profit.
3. Give evidence in favor and against the Hypothesis.
Evidence in Favor of Market Efficiency
-all public information is assumed to be incorporated
into the stock price almost immediately. In this case
there is potential for share prices to be inaccurate or
outdated because of private information that hasn't
yet been shared. The implication is that there is
limited potential for fundamental analysis to work
when it's based on access to more accurate private
information.
- Investment analysts and mutual funds don't beat
the market.
- Stock prices reflect publicly available info:
anticipated announcements don't affect stock price.
- Stock prices and exchange rates close to random
walk; if predictions of P big, Rof R* predictions
of P small.
- Technical analysis does not outperform market.
Against Market Efficiency
-only public market information is assumed to be
incorporated into the share price. If there is breaking
news about a company, weak-form efficient Market
hypothesis assumes that it is digested rapidly by the
market and that the change in price accurately
reflects the implications of that news. Other public
and private information is not assumed to be part of
the price, which implies that there is more potential
for fundamental analysis to work when it's based on
an information advantage
- The small-firm effect seems to have diminished in
recent years but is still a challenge to the theory of
efficient markets.
- Various theories have been developed to explain
the small-firm effect, suggesting that it may be due
to the rebalancing of portfolios by institutional
investors, tax issues, low liquidity of small-firm
stocks, large information costs in evaluating small
firms, or an inappropriate Measurement of risk for
small-firm stocks.
- The January Effect is the tendency of stock prices
to experience an abnormal positive return in the
month of January that is predictable and, hence,
inconsistent with random-walk behavior.
- Investors have an incentive to sell stocks before
the end of the year in December because they can
then take capital losses on their tax return and
reduce their tax liability. Then when the new year
starts in January, they can repurchase the stocks,
driving up their prices and producing abnormally
high returns.
- Although this explanation seems sensible, it does
not explain why institutional investors such as
private pension funds, which are not subject to
income taxes, do not take advantage of the
abnormal returns in January and buy stocks in
December, thus bidding up their price and
eliminating the abnormal returns.