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Flashcards in Two Pillars of Asset pricing Deck (7)
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1

Three phases of efficient market hypothesis

Strong
Semi-strong
Weak

2

Strong EMH

prices incorporate all information (also
non-public)

3

Semi-strong EMH

only public information is
incorporated in prices

4

Weak EMH

prices incorporate only information of
past price movements

5

The problem in EMH

We want to know whether markets are efficient
→ we need to determine what is “efficient” →
we use a model to test the efficiency →
Imagine the model shows that markets are NOT
efficient:
a) Model is wrong and we have to test markets again
b) Model is correct and markets are inefficient
→ Joint hypothesis problem

6

Joint Hypothesis problem

The Joint Hypothesis problem refers to that testing for market efficiency is problematic, or even impossible. Any attempts to test for market (in)efficiency must involve an equilibrium asset pricing models. It is not possible to measure 'abnormal' returns without expected returns predicted by pricing models.

7

Joint Hypothesis problem in case of inflation

Expected stock returns are higher when expected
inflation is lower; so we have JHP:
– Poor inflation forecasts (so markets are inefficient) or
– Or our model is wrong and actually we should expect
such strange relationship AND markets are efficient