Random Walk and EMH

Dr Aloysius Edward J

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 Random Walk

 Random Walk: the theory that stock price

movements are unpredictable, so there is no way to
know where prices are headed
– Studies of stock price movements indicate that they do not
move in neat patterns
– This random pattern is a natural outcome of markets that
are highly efficient and respond quickly to changes in
material information
– Definition of random walk: The best prediction of the future
price is today’s price.
 Efficient Market Hypothesis
 Definition
 Informational Efficiency
 Forms of Efficiency
– Weak Form
– Semi-Strong Form
– Strong Form
 Semi-Efficient Market Hypothesis
 Security Prices and Random Walks

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 Efficient Market

 Efficient Market: a market in which securities reflect

all possible information quickly and accurately
 To have an efficient market, you must have:
– Many knowledgeable investors actively analyzing and trading
stocks
– Information is widely available to all investors
– Events, such as labor strikes or accidents, tend to happen
randomly
– Investors react quickly and accurately to new information
 Definition
 The efficient market hypothesis (EMH) is the
theory supporting the notion that market prices are
in fact fair
– Under the EMH, security prices fully and fairly (i.e.,
without bias) reflect all available information about the
security
– Since the 1960’s, the EMH has been perhaps the most
important paradigm in finance
– Whether markets are efficient has been extensively
researched and remains controversial

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 Efficient Market
 An efficient market is one in which the market price of
a security is an unbiased estimate of its intrinsic value.
 Note that market efficiency does not imply that the
market price equals intrinsic value at every point of
time.
 All that it says that the errors in the market prices are
unbiased.
 This means that the price can deviate from the intrinsic
value but the deviations are random and uncorrelated
with any observable variable.

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 EMH
 Informational efficiency is a measure of
how quickly and accurately the market
reacts to new information
– This is the type of efficiency with which the EMH
is concerned
– The market is informationally very efficient
 Security prices adjust rapidly and fairly accurately to
new information

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 Forms of Market Efficiency
 Eugene Fama’s original formulation of the Efficient
Market Hypothesis established three forms of market
efficiency, based on the level of information reflected in
security prices:
1. Weak form = prices reflect all past market level (price
and volume) information
2. Semi-strong form = prices also reflect all publicly
available fundamental company and economic
information
3. Strong form = prices also reflect all privately held
information that would affect the value of the company
and its securities

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 Weak Form
 Definition
 Charting
 Runs Tests

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 Definition
 The weak form of the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past
– The current price is a fair one that considers
any information contained in the past price data
– Charting techniques are of no use in predicting
stock prices

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 Definition (cont’d)
Example

Which stock is a better buy?

Stock A

Current Stock Price

Stock B

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 Definition (cont’d)
Example (cont’d)

Solution: According to the weak form of the EMH, neither

stock is a better buy, since the current price already
reflects all past information.

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 Charting
 People who study charts are technical
analysts or chartists
– Chartists look for patterns in a sequence of
stock prices
– Many chartists have a behavioral element

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 Semi-Strong Form
 The semi-strong form of the EMH states that
security prices fully reflect all publicly
available information
– e.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.

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 Semi-Strong Form (cont’d)
 Academic research supports the semi-
strong form of the EMH by investigating
various corporate announcements, such as:
– Stock splits
– Cash dividends
– Stock dividends
– Examined through “event studies”
 This means investors are seldom going to
beat the market by analyzing public news

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 Strong Form
 The strong form of the EMH states that
security prices fully reflect all relevant public
and private information
 This would mean even corporate insiders
cannot make abnormal profits by using
inside information about their company
– Inside information is information not available
to the general public

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 Criticism
 The advocates of efficient market hypothesis argue
that it is not surprising that several anomalies and
puzzles have been found. When data is mined
extensively, one is bound to find a number of
patterns. Even if inefficiencies exist, it is difficult to
take advantage of them.
 The EMH, like all theories, is an imperfect and
limited description of the stock market. However, at
least for the present, there does not seem to be a
better alternative.
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