Efficient Market Hypothesis, Behavioral Finance, and Market Analysis

This report provides a comprehensive analysis of the Efficient Market Hypothesis (EMH), exploring its three variations (weak, semi-strong, and strong forms) and the implications for market efficiency. It discusses the correlation between stock returns, the reasons for positive market returns, and whether consistent profits violate the EMH. The report also delves into behavioral finance, identifying common biases such as conservatism bias, regret avoidance bias, and representation bias, and examines the behavioral critique of the EMH, including limitations and investment barriers. Furthermore, it addresses fundamental risk, limits to arbitrage, and stock market anomalies, providing examples and explanations. The report concludes by emphasizing the role of stock market anomalies in market management and offering suggestions for improvement.

Question and Answers

Table of Contents
INTRODUCTION...........................................................................................................................4
Main Body - ...................................................................................................................................4
1 Elaborate the three variations of EMH (Efficient Market Hypothesis)-..................................4
2 If market are efficient,what should be the correlation coefficient between stock returns for
non-.............................................................................................................................................4
overlapping time periods -..........................................................................................................4
3 If prices are as likely to increase or decrease, why do investors earn positive returns from
the market on average -...............................................................................................................4
4 A successful firm like Apple has consistently generated large profits for years. Is this a
violation of the EMH -................................................................................................................5
5 At a cocktail party, your co-worker tells you that he has beaten the market for each of the
last three years. Suppose you believe him. Does this shake your belief in efficient markets-....5
6 Which of the following statements are true-............................................................................5
7Suppose that, after conducting an analysis of past stock prices, you come up with the
following observations. Which would appear to contradict the weak form of the EMH-..........5
8 Which of the following observations would provide evidence against the semi-strong form
of the efficient market theory and explain-.................................................................................5
9 Suppose that as the economy moves through the business cycle. For example, in a recession
when people are concerned about their jobs, risk tolerance might be lower and risk premiums
might be higher. In a booming economy, tolerance for risk might be higher ans risk might be
higher and risk premiums lower-................................................................................................6
a) Would a predictably shifting risk premium as described here be a violation of the efficient
market hypothesis-......................................................................................................................6
b) How might a cycle of increasing and decreasing risk premiums create an appearance that
stock prices overreact, first falling excessively and then seeming to recover -..........................6
10. Identify a behavioural bias that your client suffers from for the following examples -........6
11. After reading about three successful investors in the The Wall Street Journal your client
decides that active investing will give him with superior trading results. What sort of
behavioural bias is your client demonstrating-...........................................................................6

12. What are the major points of the behavioural critique of the efficient market hypothesis.
What are some limitations with the criticism - ..........................................................................7
13 What are some feasible investment barrier of the behavioural criticism -.............................7
14 What do you mean by fundamental risk, and why may such risk allow behavioural biases
to persist for long run- ................................................................................................................7
15 What is the meaning of 'limits to arbitrage'-..........................................................................7
16 What refers to stock market anomaly. Give three examples of stock market anomalies - ...7
CONCLUSION ...............................................................................................................................8
REFERENCES................................................................................................................................9

INTRODUCTION
EMH (Efficient Market Theory) is an investment theory which refers that the prices of
financial instruments contemplate all available market figures. Therefore, investors cannot
override each other by scrutinizing the stocks and adopting different market strategies.
According to this theory, investors can only earn high returns by taking more crucial risks in the
market. EMH (Efficient Market Theory) have some variations and limitations as well which
constitute different market efficiency levels (Garcia and et.al., 2020).
Main Body -
1 Elaborate the three variations of EMH (Efficient Market Hypothesis)-
 Weak- This form suggests that all past information is priced into securities and different
approach implemented by traders cannot yield coherent returns.
 Semi-strong - It is based on the assumptions of the weak form and accept that the market
prices make quick acclimation in response to any new public information that is revealed.
 Strong – It states that the findings related to public or not publicly-known is completely
accounted for in current stock prices and no information can give an investor an
advantage.
2 If market are efficient,what should be the correlation coefficient between stock returns for non-
overlapping time periods -
The correlation coefficient between stock returns for 2-non overlapping periods should be
zero. If not, one could use returns from one period to forecast returns in later periods and make
abnormal gains.
3 If prices are as likely to increase or decrease, why do investors earn positive returns from the
market on average -
Over the long-run, there is an expected upward shift in stock prices based on their fair forecasted
rate of return. The fair expected return over any single day is very little, so that on any day the
price is effectually equal or likely to rise or fall. Although, over long run, the small expected
daily returns accumulate and upward moves are more certain probably than downward ones.

4 A successful firm like Apple has consistently generated large profits for years. Is this a
violation of the EMH -
No, this is not a violation of EMH. Apple persistently making large profits does not
imply that stock market investors who purchased apple shares after its achievement already was
evident would have realized excess return on their investments (Gervasio 2021).
5 At a cocktail party, your co-worker tells you that he has beaten the market for each of the last
three years. Suppose you believe him. Does this shake your belief in efficient markets-
No, the belief of random move naturally expects there can be some people who beat the
market and some people who do not. The information provided, although fails to consider the
risk of the investment. Higher risk investments should have higher returns.
6 Which of the following statements are true-
B. It implies that prices reflect all available information – It is the definition of the
Efficient market.
7Suppose that, after conducting an analysis of past stock prices, you come up with the following
observations. Which would appear to contradict the weak form of the EMH-
(a)The average rate of return is significantly greater than zero – This is appear to
contradict the weak form because it only refers that the stock has a positive rate of return but it
does not say why or how we obtained the data (Kim and et.al., 2020).
8 Which of the following observations would provide evidence against the semi-strong form of
the efficient market theory and explain-
According to the theory of semi-strong form of efficiency, the market must be able to
reflect all publicly available information related to the future prospects of a firm,earnings or
returns. As per given problem, the stocks with low PfiE ratio (Price to earning ratio) provide
positive abnormal returns over the long run. This is publicly available information. Therefore,
the correct answer is option c.

9 Suppose that as the economy moves through the business cycle. For example, in a recession
when people are concerned about their jobs, risk tolerance might be lower and risk
premiums might be higher. In a booming economy, tolerance for risk might be higher ans
risk might be higher and risk premiums lower-
a) Would a predictably shifting risk premium as described here be a violation of the efficient
market hypothesis-
The move in risk premium described due to business cycle is not in violation of the
EMH. The predictability shifting risk premiums are merely in reaction to shifting levels of risk
held by shareholders.
b) How might a cycle of increasing and decreasing risk premiums create an appearance that
stock prices overreact, first falling excessively and then seeming to recover -
This happens because risk premium gives investors a compensation for tolerating extra
risk. But this risk investment also gives them opportunities to earn larger returns but with
limitation of losing some or all of their capital which results in misbehave in stock prices.
10. Identify a behavioural bias that your client suffers from for the following examples -
a) Your client is slow to update their beliefs when given new evidence - Conservatism Bias
b) Investors are reluctant to bear losses due to their unconventional decisions – Regret
Avoidance Bias (Liu, Xia and Xiao 2020).
c) Investors exhibit less risk tolerance in their retirement accounts versus their stock
accounts – Mental Accounting Bias.
d) Investors are unwilling to sell stocks with unrealised losses – Disposition Effect Bias.
e) Investors disregard sample size when forming views about the future from the past –
Representation Bias.
11. After reading about three successful investors in the Wall Street Journal your client decides
that active investing will give him with superior trading results. What sort of behavioural
bias is your client demonstrating
The behavioural bias showed here is Representation bias and the sample size is not
considered while doing future forecasting of decisions.

12. What are the major points of the behavioural critique of the efficient market hypothesis.
What are some limitations with the criticism.
The preface of behavioural critique of EMH is that traditional financial theory which
ignores how real people make decisions and those persons make a difference. Behavioural
finance may indicate examples of market slack, but they give no vision regarding how to exploit
such event. The strength depends upon observed market slack and unexplained market
behaviour. There are many deviations, yet many can be reverse described.
13 What are some feasible investment barrier of the behavioural criticism -
An unfortunate result of behavioural finance is a tendency for shareholders to assume
more than actual is claimed by the field. It does not propose to be a forecaster of future returns.
Investors should be wary of people purporting to offer excess returns under the facade. Such
claims are likely to be wrong (McKelvey and Yalamova 2018).
14 What do you mean by fundamental risk, and why may such risk allow behavioural biases to
persist for long run-
Fundamental risk states that if a security is wrongly priced then it can be risky to try to
utilize the mispricing because the improvement to price could happen after the marketer's
investing horizon. It restrict arbitrageurs to take positions in mispriced securities. So arbitrageurs
not able to take advantage of it
15 What is the meaning of 'limits to arbitrage'-
Limits of arbitrage : Arbitrage is the purchase and sale of the same assets in distinct
market to make profit. Arbitrageurs may not make money and they can not take large position
due to high risks.
Here are some fundamental risks of limits of arbitrage
market can stay blind longer than company can stay solvent.
Inner value and market value may take too long to coverage
16 What refers to stock market anomaly. Give three examples of stock market anomalies -
Stock market anomalies is the most popular 'Efficiency market hypothesis” and it
believes that necessary information should be already reflected by the cost. It include three forms

of stock market anomalies are weak form, semi-strong form and strong form. Examples of stock
market anomalies are minor book value, lapse and ignoring stocks.
CONCLUSION
From the above prepared report, it can be asserted that there are many forms of stock market
anomalies which help in managing market. It explains fundamental risk too and provide
suggestions as how it can be improved. It also takes in account risks related to job cost and
recession as well.

REFERENCES
Books and Journals
Garcia, M.M. and et.al., 2020. Forecast model for financial time series: An approach based on
harmonic oscillators. Physica A: Statistical Mechanics and its Applications. 549.
p.124365.
Gervasio, G., 2021. Finanza frattale ed analisi tecnica.
Kim, J.V. and et.al., 2020. S1465 Extramedullary Hematopoiesis Causing Acute
Cholecystitis. Official journal of the American College of Gastroenterology| ACG. 115.
p.S694.
Liu, B., Xia, X. and Xiao, W., 2020. Public information content and market information
efficiency: A comparison between China and the US. China Economic Review. 60.
p.101405.
McKelvey, B. and Yalamova, R., 2018. Financial resilience engineering: toward automatic
action formulas against risk and reckless endangerment. In Governance and Control of
Financial Systems (pp. 133-148). CRC Press.