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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

A researcher finds that a trading rule based on the past 12 months of share prices earns consistent abnormal returns after allowing for risk and costs, but finds no abnormal returns from rules using only the most recent week's prices. Which statement about the Efficient Markets Hypothesis is most consistent with the evidence on the 12-month rule?

The weak form of EMH is violated. Weak-form efficiency means past prices carry no information that can earn abnormal returns, so a profitable rule based on historical prices directly contradicts it, and the stronger forms, which include it, fail as well.

  1. AThe weak form of EMH is violatedCorrect
  2. BThe weak form holds but the semi-strong form is violated
  3. CThe strong form holds but the weak form is violated
  4. DOnly the strong form is violated
  5. All three forms of EMH hold

Explanation

The weak form says current prices already reflect all information in past price history, so technical rules based on past prices cannot earn abnormal returns. A rule using 12 months of past prices that does earn abnormal returns therefore contradicts the weak form. Since the strong and semi-strong forms both include the weak form, they would be violated too, so the weak-form statement is the one that is directly shown.

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