Question

Answer please the Questions below in WRITTEN FORM ONLY

9) In studying the EMH, what did Fama and French conclude? Are there anomalies? If so how can these be explained?

9.1) When stock returns exhibit positive serial correlation, what does this mean and why would this violate EMH ?

Answer 1

(9) As per the Fama and French Model, we have

Ri = Rf + beta1*(Rm - Rf) + beta2*SMB + beta3*HML

Ri: return on security/portfolio

Rm - Rf: market risk premium

SMB: Returns of small company - big company (size in terms of market capitalization)

HML: Returns of company with high book/price value - low book/price value

The model states that all the betas and coefficients are statistically significant and positive. As per the model, there are three types of markets, the characteristics for each of them is talked about below

- Weak form: Current stock price incorporates all information hidden in past prices hence technical analysis is useless.

- Semi strong form: Current stock price incorporates all publically available information hence both technical and fundamental analysis are useless

- Strong form: Current stock prices incorporates all publically information as well as previlged insider information.Hence technical,fundamental analysis and insider information is useless.

The anomaly in the model is that the market is very efficient to discover high growth small companies & will pump in money in these small companies to make them big, and thus reduce the excess growth return small companies have very quickly.

(10) A positive serial correlation between stock returns exhibits that the returns for the two stocks move in the same direction, i.e. both the stocks returns rise or fall at the same time. It violates the EMH because in this case r=1, and as per EMH the stock returns are not related to each other