Definition of Efficient Markets Hypothesis

Efficient Markets Hypothesis

The hypothesis that securities are typically in equilibrium--that they are fairly priced in the sense that the price reflects all publicly available information on the security.

Auction markets

markets in which the prevailing price is determined through the free interaction of
prospective buyers and sellers, as on the floor of the stock exchange.

Cash markets

Also called spot markets, these are markets that involve the immediate delivery of a security
or instrument.
Related: derivative markets.

Coefficient of determination

A measure of the goodness of fit of the relationship between the dependent and
independent variables in a regression analysis; for instance, the percentage of variation in the return of an
asset explained by the market portfolio return.

Correlation coefficient

A standardized statistical measure of the dependence of two random variables,
defined as the covariance divided by the standard deviations of two variables.

Derivative markets

markets for derivative instruments.

Efficient capital market

A market in which new information is very quickly reflected accurately in share
prices.

Efficient diversification

The organizing principle of modern portfolio theory, which maintains that any riskaverse
investor will search for the highest expected return for any level of portfolio risk.

Efficient frontier

The combinations of securities portfolios that maximize expected return for any level of
expected risk, or that minimizes expected risk for any level of expected return.

Efficient Market Hypothesis

In general the hypothesis states that all relevant information is fully and
immediately reflected in a security's market price thereby assuming that an investor will obtain an equilibrium
rate of return. In other words, an investor should not expect to earn an abnormal return (above the market
return) through either technical analysis or fundamental analysis. Three forms of efficient market hypothesis
exist: weak form (stock prices reflect all information of past prices), semi-strong form (stock prices reflect all
publicly available information) and strong form (stock prices reflect all relevant information including insider
information).

Efficient portfolio

A portfolio that provides the greatest expected return for a given level of risk (i.e. standard
deviation), or equivalently, the lowest risk for a given expected return.
efficient set Graph representing a set of portfolios that maximize expected return at each level of portfolio
risk.

Emerging markets

The financial markets of developing economies.

Expectations hypothesis theories

Theories of the term structure of interest rates which include the pure
expectations theory, the liquidity theory of the term structure, and the preferred habitat theory. These theories
hold that each forward rate equals the expected future interest rate for the relevant period. These three theories
differ, however, on whether other factors also affect forward rates, and how.
Expectations theory of forward exchange rates A theory of foreign exchange rates that holds that the
expected future spot foreign exchange rate t periods in the future equals the current t-period forward exchange
rate.

Information Coefficient (IC)

The correlation between predicted and actual stock returns, sometimes used to
measure the value of a financial analyst. An IC of 1.0 indicates a perfect linear relationship between predicted
and actual returns, while an IC of 0.0 indicates no linear relationship.

Internally efficient market

Operationally efficient market.

Liquidity preference hypothesis

The argument that greater liquidity is valuable, all else equal. Also, the
theory that the forward rate exceeds expected future interest rates.

Markowitz efficient frontier

The graphical depiction of the Markowitz efficient set of portfolios
representing the boundary of the set of feasible portfolios that have the maximum return for a given level of
risk. Any portfolios above the frontier cannot be achieved. Any below the frontier are dominated by
Markowitz efficient portfolios.

Markowitz efficient portfolio

Also called a mean-variance efficient portfolio, a portfolio that has the highest
expected return at a given level of risk.

Markowitz efficient set of portfolios

The collection of all efficient portfolios, graphically referred to as the
Markowitz efficient frontier.

Mean-variance efficient portfolio

Related: Markowitz efficient portfolio

Negotiated markets

markets in which each transaction is separately negotiated between buyer and seller (i.e.
an investor and a dealer).

Operationally efficient market

Also called an internally efficient market, one in which investors can obtain
transactions services that reflect the true costs associated with furnishing those services.

Overreaction hypothesis

The supposition that investors overreact to unanticipated news, resulting in
exaggerated movement in stock prices followed by corrections.

Perfectly competitive financial markets

markets in which no trader has the power to change the price of
goods or services. Perfect capital markets are characterized by the following conditions: 1) trading is costless,
and access to the financial markets is free, 2) information about borrowing and lending opportunities is freely
available, 3) there are many traders, and no single trader can have a significant impact on market prices.

Spot markets

Related: cash markets

Correlation Coefficient

A measure of the tendency of two variables to change values
together

coefficient of correlation

a measure of dispersion that indicates the degree of relative association existing between two variables

coefficient of determination

a measure of dispersion that
indicates the “goodness of fit” of the actual observations
to the least squares regression line; indicates what proportion
of the total variation in y is explained by the regression model

coefficient of variation

a measure of risk used when the standard deviations for multiple projects are approximately
the same but the expected values are significantly different

input-output coefficient

a number (prefaced as a multiplier
to an unknown variable) that indicates the rate at which each
decision variable uses up (or depletes) the scarce resource

Correlation coefficient

A statistic in which the covariance is scaled to a
value between minus one (perfect negative correlation) and plus one (perfect
positive correlation).

Efficient frontier

A graph representing a set of portfolios that maximizes
expected return at each level of portfolio risk. See Markowitz model.

capital markets

markets for long-term financing.

efficient capital markets

Financial markets in which security prices rapidly reflect all relevant information about asset values.

financial markets

markets in which financial assets are traded.

Accelerationist Hypothesis

Belief that an effort to keep unemployment below its natural rate results in an accelerating inflation.

Permanent Income Hypothesis

Theory that individuals base current consumption spending on their perceived long-run average income rather than their current income.

Beta coefficient

A measurement of the extent to which the returns on a given stock move with stock market.

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