The Efficient Markets Hypothesis TranscriptThe Efficient Markets HypothesisTranscriptDate: Thursday, 28 April 2016 - 6:00PMLocation: Barnard's Inn Hall28 April 2016The Efficient Markets HypothesisProfessor Jagjit Chadha"Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset andferocity were foreseen by nobody. What matters in such circumstances is not just to predict the nature of theproblem but also its timing. And there is also finding the will to act and being sure that authorities have as part oftheir powers the right instruments to bring to bear on the problem."Letter from British Academy to H M The Queen, 2009."One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value offinancial assets, like the declines that followed the failure of Lehman Brothers in September....The main lesson weshould take away from the EMH for policymaking purposes is the futility of trying to deal with crises andrecessions by finding central bankers and regulators who can identify and puncture bubbles. If these peopleexist, we will not be able to afford them."Robert Lucas, 2009.IntroductionThe efficient markets hypothesis (EMH) has taken a 'hell of a beating' in the 9 years since the start of thefinancial crisis. The very idea that we thought markets were efficient would seem now to beggar belief. Scleroticand highly volatile markets, as well as all kinds of alleged malpractices, do not seem to correspond to our innatenotions of efficiency. It would appear to many casual observers that increasing levels of financial instability hasrun in tandem with moves to greater degrees of market deregulation and would seem to have been anythingother than efficient. But that view of the hypothesis, perhaps, has in mind other notions of efficiency to do withthe allocation of scarce capital, the operation or organisation of markets or portfolios that are able to minimisethe variance of a return for a given expected payoff.In fact the efficient markets hypothesis that makes no necessary claims about the social optimality of all financialmarkets, which may well be constrained or distorted by all kinds of incentives, rigidities, regulation or policy-induced moral hazard. It simply says any individual will use all the information at their disposal to decide on theappropriate price of any given asset and that information has been used, the price will move to reflect thatinformation. The idea of efficiency in this sense is simply that agents have an incentive to trade any informationthat they may have so that it becomes publicly available in the new price of the asset. By the process ofproviding incentives to decant private information into the public domain, the traded price is conditioned on allrelevant information, and accurately reflects the payoffs and their probabilities in all states of nature.The question posed by the Queen as to "why had nobody noticed that the credit crunch was on its way?" is, ofcourse, very important but it is related to the build of risks over a long expansion in economic activity that onemight think ought to have been reflected in the changes in some asset prices, particularly those which werevulnerable to these risks, for example, the shares of financial institutions. There are two responses. Financialprices may be informationally efficient and gauge that the probability of a bad event, involving a low or negativereturn, is non-zero but low and yet, after the fact, if and when that bad event occurs, which it must almostcertainly if we run the system for long enough, it may look as though the probability was badly underestimated.Alternatively, the price may not adjust even if the probability of a bad event has risen because it is thought thatthere is some kind of private or public insurance that limits the extent of the low or negative payoff.The efficient markets hypothesis really hinges on the incentives to trade all information and to gauge the likelyreturns in all possible states of nature from holding a given asset. The forecasts we make are this all conditionalon states (good, bad or indifferent) and not unconditional with respect to whether a particular state will occurwith probability one. The price of that asset will then adjust to reflect the expected payoff from that asset andany premium required for bearing risk. What the EMH does require is some form of rationality in expectationsand negligible costs of trading. And so we shall first turn to the formation of rational expectations.Rational ExpectationsWhen we invest in a financial market, although we might use the history of past payoffs as a guide to expectedpayoffs from holding an asset, for the calculation of return expectations are actually key because we areinterested in the prospective payoff from an asset across all states of nature and thence its implied return,which relates the payoff to the price of purchase. What we are trying to do is to match our subjective priorsabout these returns to their objective distribution. And under a standard form of expected, or Bernoulli, utility, this expected return is the sum of all the likely payoffs pre-multiplied by the respective probabilities of each stateof nature. Once we have the expected or prospective payoff, the price of the asset can jump so that the returncompensates you for the risk of that asset. If, for example, we think that two different assets will yield the samepayoff, the one with more risk will trade at a lower price and thus give a higher rate of return. We therefore needexpectations about payoffs and risk to price an asset, which is the opportunity cost of its purchase, and thesederive ultimately from the collection and analysis of information and the development of a number of beliefs.One lacuna to this story was highlighted by Keynes (1936) in his analogy of asset prices as Beauty Contests. Onthe one rational paw, what matters to me for the asset price is its actual or fundamental pay-off across all statesof nature and that means the actual amount of cash I get in my grubby paw when a good or a bad state occurs.On the other grubby paw, I may care less about the actual cash but what I think that other people think