Critically discuss how the empirical exercises in the assignment relates to the literature on testing for market efficiency.
I start off by defining the efficient market hypothesis and how academics today test whether it exists or not. Then there is a discussion regarding the testing and the literature on the subject of market efficiency. Further I talk about our assignment and the different questions and exercises we are given, and how it links to the literature of testing market efficiency. Finally I conclude by comparing our work against the academic literature.
The efficient market hypothesis (EMH) was first described by Eugene Fama in 1970, where he stated that the price of a security reflects all available information. (1970,p. 383) The investors in the markets are considered to be rational hence they make few mistakes. He further explained that the market had three forms of efficiency: weak –, semi-strong –, and strong form. The markets are considered to be efficient if investors cannot consistently beat the market and earn abnormal profits on their portfolios. Abnormal profits is defined as the difference between the actual return and the return needed by investor to compensate for the risk taken on by an investor (p. 34, Hoover) Ever since Fama first described the EMH, academics have been trying to test whether the hypothesis is true or not. So the last decade, a major part of the research within finance is looking at the predictability of the abnormal returns using numerous models with different variables. (p.35, Hoover)
In order to test for predictable abnormal returns we have to be able to properly measure risk and then convert it to an appropriate level of return. After the EMH was published, a whole range of different pricing models saw the light. One of the most famous models is the Capital Asset Pricing Model (CAPM) by Sharpe (1962), Lintner (1965) and Black (1972). They found a relationship between the risk free rate and an assets beta, where the beta is defined as the assets sensitivity to the market changes. The CAPM was later revised and in 1992 Fama and French introduced the three-factor model. They found that excess market returns, a size variable (SmB) and a book-to-market (HmL) variable could describe market behaviour. This is the “starting point” for my assignment.
In the assignment we look for explanatory variables to try and explain the excess return in a specified industry. We start with the Fama/French three-factor model where we do statistical test on the regression model. We look for additional
