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A passage in my textbook is confusing me. It states that various market indicators (e.g. yield spreads between high/low grade bonds, earnings yields) lead to predictability in the security's risk premium, not risk adjusted abnormal returns, which is therefore not a violation of the efficient markets hypothesis.

The EMH is maintains that all securities prices affect available information. If such indicators signal something about a security's risk premium, doesn't this mean that this piece of information should have been reflected, but was not in the first place? How is this consistent with the EMH?

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    $\begingroup$ It is simply that when the yield spread is high, the EMH interprets this as an indicator of higher risk and therefore it is OK for the shareholders to collect a bigger risk premium. EMH says there is no extra profit once you have correctly accounted for risk. Extra profit due to an increase in risk is OK. $\endgroup$ – Alex C Aug 29 '19 at 0:44
  • $\begingroup$ So will it be correct to say that any sort of signal that affects a stock's risk profile is new information that necessitates a price change, whereas a signal that affects abnormal returns is news that should have been applied already (since it doesn't affect risk)? $\endgroup$ – lithium123 Aug 29 '19 at 0:53
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    $\begingroup$ @Lithium123: Your last comment is correct in that, as Alex C said, EMH is referring to obtaining extra return without an increase in risk. For example, suppose you found that losers last week will outperform this week and vice versa. ( and this phenomena was found to be consistent ). This would be an example of a violation of the EMH. $\endgroup$ – mark leeds Aug 29 '19 at 3:51
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This one is gloriously semantic. The critical bit is adding the qualifying words "abnormal" and "risk-adjusted".

Imagine for example's sake a market stylized by two groups of stocks: debt-heavy telecoms companies, and cash-rich tech companies. A change in credit spreads will obviously work to the relative benefit of one group, and to the relative cost of the other. Which is saying nothing more than different stocks have different credit betas.

For the EMH to hold, you have to believe that all available information is reflected in the current valuation of credit spreads; and thus the future path of credit spreads is unpredictable.

Future news and the surprise this represents will cause credit spreads to move. The effects this will have on different stocks is (relatively) predictable. But putting a predictable multiplier on a random input still gives you a random output. Plus the residuals of my companies' "alpha" excluding these effects, will still (in theory) be random noise. If return = beta * market + error, then the EMH holds if market and error are both random.

When I go and buy dinner with my returns, neither I nor the supermarket care much whether these were generated by alpha, this beta, or that one. However, people who write textbooks seem to get hot under the collar about such things ;-)

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