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Efficient Market Hypothesis

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Efficient Market Hypothesis * EMH emerged in the 1950s due to early application of computers in analysis of time series behaviour of economic variables. * The general idea of EMH is that markets incorporate all available information into all prices and the assumptions are that there is elimination of riskless profit opportunities and all prices of stocks are equal to their fundamental value and we have Rational expectations: agents use optimal forecasts based on all information available so as to minimise the forecast error. * In 1970 Eugine Fama defined EMH and divided it into 3 main forms. There are three main forms of EMH that are usually tested by researchers. * Weak form states that past prices have no influence on current prices or in other words it is impossible to use past information to predict future prices since all this info is already priced into stocks * Semi strong form states that market efficiency takes into account all publicly available information, past and present, such as financial reports, public announcements * Strong form states that all information, including that of insiders is reflected in prices and therefore cannot be useful in price forecasting * Early tests which focus on the performance of investment analysts and mutual funds tend to support the EMH in that past good performance does not indicate that an advisor or mutual fund will perform well in the future. For example – Jensen (1967) measures the predictive abilty of 115 mutual fund managers in period 1945-64 and finds that on average they were not able to beat the buy and hold set. * Furthermore the Wall Street Journal used to have a feature called “Investment dartboard” and it turned out that the dartboard beat advisers just as much as they beat the dartboard * Tests for the weak form of EMH normally consist of testing the

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