Efficient Market Hypothesis and Random Walk definitions
Efficient Market Hypothesis (EMH): stock prices should reflect all available information.
Random walk: since new information is unpredictable, the stock price must move unpredictably
3 Versions of EMH
Weak form: prices reflect all information that can be derived from examining market data
Semistrong form: stock prices reflect all publicly available information
Strong form: stock prices reflect all information relevant to the firm, including that not publicly available (inside information)
Event study definition
Since price changes reflect new information, it is possible to determine the importance of an event by measuring the resulting price changes.
3 issues with determining whether a market is efficient
- Magnitude Issue: It is hard to assess how much a manager contributed if the additional return is small given the volatility of the market
- Selection Bias Issue: Once an investment scheme becomes public, it will no longer generate abnormal returns. Therefore only schemes that do not work will be reported. It is possible that techniques that do actually work exist, but are not being reported.
- Lucky Event Issue: the number of investors is so large that some have to make huge returns just by chance
Role of fund manager under EMH
- Diversification: selects a diversification strategy to eliminate firm-specific risk
- Reflects tax considerations
Reflect the unique risk profile of the investor
