BUS202: Principles of Finance

Efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient and should therefore move unpredictably.

TERM

• Martingale model

  In probability theory, a martingale is a model of a fair game where knowledge of past events will never help to predict future winnings.

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". As a result, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.

There are three major versions of the hypothesis: "weak," "semi-strong," and "strong. " The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH also claims that prices instantly reflect even hidden or "insider" information. Critics have blamed the belief in rational markets for much of the late-2000's financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future. Market efficiency is a simplification of the world which may not always hold true. The market is practically efficient for investment purposes for most individuals.

Random-Walk Model

Historically, there was a very close link between EMH and the random-walk model and then the Martingale model. The random character of stock market prices was first modelled by Jules Regnault, a French broker, in 1863 and then by Louis Bachelier, a French mathematician, in his 1900 PhD thesis, "The Theory of Speculation". His work was largely ignored until the 1950's; however, beginning in the 1930's scattered,independent work corroborated his thesis. A small number of studies indicated that U.S. stock prices and related financial series followed a random walk model. Research by Alfred Cowles in the '30s and '40s suggested that professional investors were in general unable to outperform the market .

Weak, Semi-strong, and Strong

The efficient-market hypothesis emerged as a prominent theory in the mid-1960's. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner. In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis, and Samuelson published a proof for a version of the efficient-market hypothesis. In 1970 Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong, and strong.

It has been argued that the stock market is "micro efficient," but not "macro inefficient". The main proponent of this view was Samuelson, who asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research based on regression and scatter diagrams has strongly supported Samuelson's dictum.