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1. Introduction
The recent global financial crisis has been characterized by high levels of volatility and trading volume. On the one hand, the sharp downturns observed in our global economy have cast doubt on the Efficient Markets Hypothesis (EMH) (see for instance, Nocera, 2009; Fox, 2009). Critics argue that asset price bubbles are evidence against efficient markets theory. For example, Soros (2009) argues that the financial crisis disproves the EMH. In a recent report, the United Kingdom’s Turner Review cites the EMH as playing a major role in the crisis[1]. Similarly, Krugman (2009) argues that the efficient markets theory played a role in inflating the asset bubble during the financial crisis. In addition to the 1987 stock market crash, Thaler presents the example of the CUBA closed-end mutual fund as a second important case in which observed prices depart from rational valuations of the securities being traded (Chicago Booth Review, 2016). Shiller (1981) argues that the excess volatility of stock prices implies that the EMH is false, subsequently describing the EMH as “the most remarkable error in the history of economic thought”[2].
On the other hand, Ball (2009) argues that the collapse of major financial institutions during the crisis does not imply market inefficiencies. That is, an efficient market cannot predict market crashes. In a similar tone, Siegel (2009) argues that the EMH implies that the prices in the markets are mostly wrong, rather than the market price always being right. Malkiel (2012) argues that critics of the EMH are using a far too restrictive interpretation of what the EMH means. Fama argues that the EMH is a good approximation, whereby prices adjust quickly to information, and that in hindsight prices can be wrong: the EMH is not entirely always true (Chicago Booth Review, 2016). Despite the presence of traders who exhibit sub-optimal behavior, Oliven and Rietz, (2004) argue that markets aggregate information efficiently. In other words, it is the presence of the marginal (market-making) traders that set prices and thus drives the efficiency of market prices.
The central insight of the EMH is that competitive financial markets exploit all available information when setting security prices. While the EMH is consistent with high levels of volatility in periods of significant uncertainty, the weak-form version of...