ABE • Efficient Market Hypothesis (EMH)

What is the Efficient Market Hypothesis (EMH)?

The idea that asset prices fully reflect all available information and adjust instantaneously and unbiasedly to new information.

What are the conditions for informational efficiency?

Agents are risk neutral, share the same discount factor, have the same information, and know others use information rationally (common knowledge of rationality).

What is the fundamental value of an asset?

The discounted sum of all expected future dividends, conditional on the information available at time t.

What is weak form efficiency?

Prices reflect all past price and volume information; technical (chartist) strategies cannot earn excess profits.

What is semi-strong form efficiency?

Prices reflect all publicly available information, including financial statements and news; neither chartist nor fundamentalist strategies can earn excess profits.

What is strong form efficiency?

Prices reflect all public and private (insider) information; no one can consistently earn excess profits.

What is the No-Trade Theorem?

If agents act rationally but have different information, trading breaks down because offers reveal private information.

What is the Grossman-Stiglitz paradox?

If markets are perfectly efficient, no one has an incentive to gather costly information, leading to inefficiency.

How does risk aversion affect asset demand?

Demand depends on expected excess returns divided by perceived risk and the agent’s risk aversion level.

What happens when agents have heterogeneous expectations?

Trade becomes possible because agents disagree, but it challenges rational expectations models.

What empirical evidence challenges the EMH?

High trading volumes, survival of technical/fundamental strategies, and large price swings not linked to news.

What is Shiller’s excess volatility test?

A test showing that actual market prices are more volatile than rational, information-based fundamental values.

What are direct tests of the EMH?

Statistical regressions of returns on past errors, day-of-week effects, or seasonal patterns to check predictability.

What does the rejection of the EMH suggest?

That behavioral models, heterogeneity, and bounded rationality might be needed to explain real market behavior.