theoretically the efficient market hypothesis should be a powerful tool for analyzin 638237

Throughout our discussion of how financial markets work, you may have noticed that the subject of expectations keeps cropping up. Expectations of returns, risk, and liquidity are central elements in the demand for assets; expectations of inflation have a major impact on bond prices and interest rates; expectations about the likelihood of default are the most important factor that determines the risk structure of interest rates; and expectations of future short term interest rates play a central role in determining the term structure of interest rates. Not only are expectations critical in understanding behavior in financial markets, but as we will see later in this book, they are also central to our understanding of how financial institutions operate. To understand how expectations are formed so that we can understand how securities prices move over time, we look at the efficient market hypothesis. In this chapter we examine the basic reasoning behind the efficient market hypothesis in order to explain some puzzling features of the operation and behavior of financial markets. You will see, for example, why changes in stock prices are unpredictable and why listening to a stock broker”s hot tips may not be a good idea. Theoretically, the efficient market hypothesis should be a powerful tool for analyzing behavior in financial markets. But to establish that it is in reality a useful tool, we must compare the theory with the data. Does the empirical evidence support the theory? Though mixed, the available evidence indicates that for many purposes, this theory is a good starting point for analyzing expectations.