Efficient market hypothesis

1. Presented By:
Shruti Singh

2.  Efficient Market is one where the market
price is an impartial estimate of the true value
of investment.
 But it does not require that the:
Market Price =TrueValue, at all point and time.
“All it requires is that the errors i.e. the
difference between the two is unbiased.”

3.  Any one of the following three conditions will lead to market
efficiency:
1. Investor Rationality – Based on fundamental values. They
bid up prices when news is favourable.
2. Independent deviation from Rationality – Irrational
traders are uncorrelated, hence errors tend to cancel out
and market price remains unbiased estimate of the intrinsic
value.
3. Effective Arbitrage – Upon realising that a security is
overpriced in relation to its fundamental value, the investor
would sell the securities and purchase relatively cheaper
securities, to hedge their position.

4.  Quick & Accurate Reaction to Information

5.  EMH has been theoretically challenged on
three grounds:
1. Investor Irrationality
2. Correlated Investor Behaviour
3. Limits to Arbitrage

6.  People and investors are not fully rational and often trade on noise
rather than information.
 Investors deviate from the standard decision making model in
economics in three fundamental ways:
i. Attitude towards risk – People do not look at the level of final
wealth they attain (as suggested by Von Neumann) rather look at
gains and losses relative to some reference point.
ii. Non-Bayesian formation of expectations – Predicting uncertain
outcomes which was generated just by chance and not by the
model they constructed.
iii. Sensitivity to decision making to how the problems are framed
– Framing influences decision-making.

7.  Investors do not deviate from rationality randomly. Rather
they employ similar strategies, as they suffer from similar
judgemental biases while processing information.
 Ex:
i. They tend to be overconfident and hence assume more
risk.
ii. They tend to extrapolate past time series and hence chase
trends.
iii. They follow market gurus and forecast and follow similar
fashion.

8.  Arbitrage is limited by two types of risk:
i. Fundamental Risk - Buying undervalued securities
tends to be risky because the market may fall further and
inflict losses.
ii. Resale Price Risk - This risk arises as the
arbitrageurs have finite horizons.This is primarily because:
Periodically pay fees for the borrowed money or
securities
Portfolio managers are evaluated every few months.