EMH Part 1 and part 2

1. Efficient Market Hypothesis
Rayenda Khresna Brahmana, PhD

2. “Homo Economicus” – The Economic Man
• Aims at maximizing self-interest
• The value he attaches to different outcomes is not affected by
emotions/past experience
• Is neutral or averse to risk
• His target is the maximization of self-interest (utility)
• Utility is the product of one or more situations’ possible outcomes (xi)
and our judgement as per their occurrence (weights)
• The Economic Man has to maximize: E[u] = ∑piu(xi)
• Expected utility (when outcome-probabilities are known)
• Decision under risk
• Subjective expected utility (when outcome-probabilities are unknown
and are subjectively estimated)
• Decision under uncertainty

3. Homo Economicus
Simply put, Homo economicus
means that human behavior are
made in many economic models.
Character:
• Rational and self-interested in
their decision-making.
• is not affected by emotions/past
experience
• have a consistent set of
preferences, and will choose the
option that offers the most utility
to them, given their budget and
other constraints.

4. Neoclassical economics
1. People have rational preferences across possible
outcomes or states of nature.
2. People maximize utility and firms maximize profits.
3. People make independent decisions based on all relevant
information.
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The assumption is rational behaviour

5. Expected utility theory
• In finance, the rational behavior assumption is well explained in
Expected Utility Theory
• The theory assumes that individuals act to maximize their utility, not
just their financial gains.
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6. Illustration
• Imagine you have two investment choices:
• Option A: A 50% chance of earning $10,000 and a 50% chance of earning $0.
• Option B: A guaranteed return of $4,000.
• According to Expected Utility Theory, a rational investor would calculate the
expected utility of each option rather than simply looking at the expected value.
• Hence, the risk averse will choose Option B.
• This theory explains why different investors may make different decisions based on
their risk tolerance

7. Risk aversion assumption
• This comes from frequent observation that most people most of the
time are not willing to accept a fair gamble:
• Would you be willing to bet me £100 that you can predict a coin flip?
• Most of us would say NO WAY!
• And if one of you says yes, I will say no, since I am risk averse.
• Risk aversion implies concavity.
Concavity = having an outline or surface that curves inwards like the interior of a circle or
sphere.......versus
Convex = having an outline or surface that curves outwards like the exterior of a circle or sphere