BEHAVIORAL ECONOMICS

EMH Definitions

The Efficient Market Hypothesis (EMH)

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Price captures all relevant information

Modern version based upon No
Arbitrage assumption
Why do we care?
Implications
Only new information effects prices
Publicly known information has no
value
Investors should index
Allocation efficiency

Behavioral Finance Economics 437

January

Eugene Famas Definition

Weak
Hypothesis

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Past prices and returns are

irrelevant

Semi-Strong
Hypothesis

All publicly known

information is irrelevant

Strong
Hypothesis

Public and private

information is irrelevant

The Malkiel View

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Burton Malkiel, author of A Random Walk

Down Wall Street
His view is that the evidence shows that
money managers cannot beat simple indexes
like the S&P500 over time
To Malkiel, that means the market is efficient

Market is efficient.

Robert Shillers View

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Prices should be based upon

fundamental future cash flows (or
dividends) and future interest rates
Prices are way too volatile as
compared to the modest changes over
time in expectations of future cash
flows and interest rates
Thus, the market is not efficient
prices are too volatile to be consistent
Market
is
not
with efficiency
efficient.
5

A Martingale Process

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Imagine a process X(t) over time
For any t, E[X(t)] is the expected value of H
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X at time
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Either:
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Xi*P(Xi) for i: 1 to n if only discrete
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values of X
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X*f(X) dX where f(X) is a probability
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density function
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Expected value is an average (weighted) I
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A Martingale Process is defined as a
E[X(t)] = X(s) for all t, s
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process with the following property:
where s > t
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Example of a Martingale Process

Coin flip
X(t) where X(0) = 0
X(t+1) = X(t) plus F(t)
Where F(t) = +1 if coin flip is heads
Where F(t) = -1 if coin flip is tails
If p(H) = P(T) =
Then E[X(t+1)] = X(t)
And E[X(s)] = X(t) where s> t
Hence X(t) is a Martingale Process

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Can stock returns be a Martingale Process?

E[P(s)] = P(t) for all s > t ?

But shouldnt stocks earn a return?
Suppose the mean return of a stock is r
Create a new variable, Q and assume
s>t
Let Q (s) = P(s)*(1+r)-n where n = s
t
Then Q(t) = P(t)
E[Q(s)] = Q(t) for all s > t
Means that, after subtracting out a
mean return of r, P(t) is a Martingale
Process

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Modern Finance Assumes

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Stock Prices (Adjusted) Follow a

Martingale Process
This is the definition of EMH in the
modern finance literature
Also known as random walk