Foundations of Finance
Summary
Fama wrote this in 1976 as a graduate text setting out the theory and the empirical evidence of financial economics as the field then stood, and it is the compact statement of the framework he had built.
The theoretical content covers portfolio theory and the derivation of efficient portfolios, the capital asset pricing model and the market model, the mathematics of return distributions and the assumptions required for mean-variance analysis, the term structure of interest rates, and the theory of efficient markets.
The efficient markets material is the core of Fama's contribution. He defines efficiency in terms of information: a market is efficient with respect to an information set if prices fully reflect it, and he sets out the weak, semi-strong and strong forms according to whether the information set is past prices, all public information, or all information including private. His methodological insight is that efficiency cannot be tested alone: any test requires a model of expected returns, so a rejection could mean either that the market is inefficient or that the asset pricing model is wrong. This joint hypothesis problem is the reason the efficiency debate has never been settled empirically, and it is Fama's own formulation.
The empirical chapters present the evidence available then: the near absence of serial correlation in returns, the failure of trading rules to produce excess returns after costs, the speed with which prices adjust to public announcements established through event studies, and the absence of persistent outperformance among mutual funds.
The book predates Fama's own later work with French on the size and value factors, which complicated the single-factor model presented here, and predates the behavioural literature entirely. It remains the clearest statement of the framework's logic by the person who built it.
Key takeaways 7
- A market is efficient with respect to an information set if prices fully reflect that information, which requires specifying the set.
- Efficiency cannot be tested alone, because every test requires a model of expected returns that might itself be wrong.
- The joint hypothesis problem means a rejection could mean market inefficiency or an incorrect asset pricing model, and the two cannot be separated.
- Stock returns show near-zero serial correlation, so past prices contain little information about future ones.
- Event studies show prices adjust to public announcements quickly enough that acting on the news produces no excess return.
- Mutual fund performance shows no persistence beyond what chance would produce, which is consistent with efficiency.
- Mean-variance portfolio analysis requires distributional assumptions that must be stated, since the results depend on them.
Who should read it
Readers with quantitative training who want the efficient markets framework and the joint hypothesis problem stated by the economist who formulated them.
About Eugene F. Fama
Robert R. McCormick Distinguished Service Professor of Finance, University of Chicago Booth School of Business; Nobel laureate in economics 2013
The efficient-markets framework and the Fama-French factor models are the primary sources on which most modern empirical asset pricing is built.
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