Reviewing Efficient Markets Hypothesis

Burton Malkiel, one of the strongest believers and propounders of of EMH makes a case here:

The world-wide financial crisis of 2008-2009 has left in its wake severely damaged economies in the United States and Europe. The crisis has also shaken the foundations of modern-day financial theory, which rested on the proposition that our financial markets were basically efficient. Critics have even suggested that the efficient–market–hypotheses (EMH) was in large part, responsible for the crises.

This paper argues that the critics of EMH are using a far too restrictive interpretation of what EMH means. EMH does not imply that asset prices are always “correct.” Prices are always wrong, but no one knows for sure if they are too high or too low. EMH does not imply that bubbles in asset prices are impossible nor does it deny that environmental and behavioral factors cannot have profound influences on required rates of return and risk premiums. At its core, EMH implies that arbitrage opportunities for riskless gains do not exist in an efficiently functioning market and if they do appear from time to time that they do not persist. The evidence is clear that this version of EMH is strongly supported by the data. EMH can comfortably coexist with behavior finance, and the insights of Hyman Minsky are particularly relevant in eliminating the recent financial crisis.

Bubbles, when they do exist are particularly dangerous when they are financed with debt. And the housing bubble and its associated derivative securities left both the consumer and financial sectors dangerously leveraged. Policy makers are unlikely to be able to identify bubbles in advance, but they must be better focused on asset-price increases that are financed with debt.

He says there are two versions of EMH:

Two fundamental tenets make up the Efficient Market Hypothesis. EMH first asserts that public information gets reflected in asset prices without delay. Information that should beneficially (adversely) affect the future price of any financial instrument will be reflected in the asset’s price today. If a pharmaceutical company now selling at $20 per share receives approval for a new drug that will give the company a value of $40 tomorrow, the price will move to $40 right away, not slowly over time. Because any purchase of the stock at a price below $40 will yield an immediate profit, we can expect market participants to bid the price up to $40 without delay.

But in other cases, the market might overreact, and it is far from clear that systematic underreaction or overreaction to news presents an arbitrage opportunity promising traders easy, risk-adjusted, extraordinary gains. It is this aspect of EMH that implies a second, and more fundamental, tenet of the hypothesis: In an efficient market, no arbitrage opportunities exist.

He says it is second one which is more important and needs to be understood. You may believe in EMH or behavioral finance, one cannot make money on arb opportunities. You may get nickels sometime but meet roadrollers most of the other times

Nice review of EMH..

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