The “Core” Theories

1. Efficient Markets Hypothesis (Fama, 1965)

2. Capital Asset Pricing Model (Sharpe / Markowitz / Miller, ~1965, Black 1972)

3. Modigliani-Miller Theorems (1958)

4. Black-Scholes Model (1973)

5. Random Walk Model (Malkiel, 1973)

6. Behavioural Finance ( ~ Kahneman / Tversky, 1998)

 Efficient Markets Hypothesis
• Acknowledged as the basis for most finance theories
• Three forms: strong, semi-strong, and weak
• Stock prices always incorporate the best information about fundamental values;
therefore, prices change only because of good, sensible information
• The price Pt of a share (or of a portfolio of shares) equals
• the mathematical expectation, conditional on all information available at the time,

• of the present value P*t of actual subsequent dividends accruing to that share or portfolio

• P*t is not known at time t and has to be forecasted.

• P*t = Pt + Ut, where Ut is a forecast error.

 Efficient Markets Hypothesis
• Implications:
• Asset prices will adjust rapidly to reflect new information

• Asset prices will therefore behave randomly

• The best predictor of tomorrow’s prices is … today’s price

• Excess profits are ruled out

• Agents cannot predict prices, and investors cannot persistently beat the market

• Invest in index funds

Efficient Markets Hypothesis
 Efficient Markets Hypothesis
• In Real Life
• How does this theory reconcile with excess volatility?

• Does the theory apply more to the aggregate market, or to individual stocks?

• Are markets crazy? Or are they a mixture of noise + efficient market fundamentals?