Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) asserts that financial markets are “efficient” denoting that the prices of traded assets already reflect all known information.  All relevant information is full and immediately reflected in a security’s market price.  Only new information will affect the price of the asset

• Fundamental analysis seeks to evaluate intrinsic value of the securities. • Technical analysis believes that the past behavior of stock prices gives an indication of the future behavior. • The basic assumption in technical analysis is that stock price movement is quite orderly and not random. • New theory questions this assumption. • Share price movements are random. It is known as Random Walk Theory.
• Because of its principal contention that share price movements represent a random walk rather than an orderly movement.

Efficient Market Hypothesis
• Financial markets are efficient :which means that
the prices of traded assets already reflect all known information. The prices of the asset reflect the collective beliefs all the investors. • Efficient Market Hypothesis implies that it is not possible to consistently outperform the market. Only new information will affect the price of assets. • Information or news in EMH is defined as anything that may affect asset prices. Prices react to information . Flow of information is random. Therefore price changes are random.

• Louis Bachelier in the early 1900 stated that stock prices are governed by a random walk.

• The random walk theory arrests that price movements will not follow any patterns or trends and that past price movement can’t be used to predict future price movements. • Engece Fama proposed Efficient Market Hypothesis first. • This Hypothesis states that all relevant information is fully and immediately reflected in a security’s market price .

.“Efficient Market” as a market where there are a large of rational. profit-maximizes who are actively competing with each other and who are trying to predict future market values of individual securities and where important current information is almost feely available to all participants.

market is said to be informationally efficient.when the cost of transfering funds is “reasonable”.Efficient Market: 3 types of market efficiently used to describe financial markets. market is said to be operationally efficient.when prices fully reflect all available information.when prices are determined in a way that equates the marginal rates of return (adjusted for risk) for all producers and savers. .   . . There are three types of market efficiency:  . market is said to be allocationally efficient.

Allocational efficiency: • A financial system exhibits allocated efficiency if it allocates capital to its highest and best use. In a market exhibiting informational efficiency. Ex: stock market investors shun security offers from firms in declining Industries. Informational efficiency: • Refers to whether prices reflect “true value”. Ex: A takeover B Stock price of A increase immediately to reflect the per share bid premium . Operational efficiency: • Refers to how large an influence transaction costs and other market frictions have on the operation of a market. asset prices incorporate all relevant information fully and instantaneously.

. • Market efficiency means that the prices are correct. They fully reflect all available information. Only way you can get higher returns is by taking more on more risk. • Competition will drive all information into the price quickly. • In financial market maximum price that investors are willing to pay for a financial asset is actually the current value of future cash payments that discounted for uncertainty in cash flow project.• Market efficiency refers to a condition in which current prices reflect all the publicly available information about a security. There is no free lunch in an efficient market. • In efficient market prices react to new information quickly and to the right extent.

The value of an efficient market • To encourage share buying Accurate pricing is required if individuals are to be encouraged to invest in cos. This is possible only if market is efficient. Mgrs take decisions only when they know that SH wealth is maximizing and is incorporated in the share price. of SH wealth is the goal of mgrs. • To help allocate resources If a badly run co in a declining industry has shares that r highly valued because the stock market is not pricing them correctly. then this co will be able to issue new capital by issuing shares. It would not become optimal allocation of resources. • To give correct signals to co managers Max. . Investors need the assurance that they are paying a fair price for their acquisition of shares and that they will be able to sell their holdings at a fair price.that the market is efficient.

As it becomes available. since new information is random.& adjust to new inf. .Random Walk Theory • It assert that prices have no memory. Therefore past and present prices can’t be used to predict future prices(as implied in technical analysis). The adjustment to this information is so fast that it is impossible to profit from it. News & events are also random & trying to predict these (fundamental analysis) is also useless. Prices move at random .

A market is semi-stron efficiemt if prices reflect all publicly available information. . • : the information set includes all information knownStrong-form efficiency to any market participant (private information). This form says that anythin that is pertinent to the value of the stock and that is known to at least one investor is.• Types of market efficiency: • Weak-form efficiency: the information set includes only the history of prices or returns themselves. A capital market is said to satisfy weak-form efficiency if it fully incorporate the information in past stock prices. in fact fully incorporated into the stock value. • Semistrong-form efficiency: the information set includes all information known to all market participants (publicly available information).

Empirical tests of EMH • Weak form efficiency: prices incorporate information about past prices • Semi-strong form: incorporate all publicly available information • Strong form: all information. including inside information .

stock prices are said to follow a random walk. then technical analysis is of no value. • Price changes should be random because it is information that drives these changes. and other market statistics provide no information that can be used to predict future prices.Weak Form Market Efficiency • The weak form of the EMH says that past prices. which by definition arrives randomly. • If stock price changes are random. • Most research supports the notion that the markets are weak form efficient. . • If the weak form of market efficiency holds. then past prices cannot be used to forecast future prices. • Since stock prices only respond to new information. volume. and information arrives randomly.

can past stock return data predict future stock data.e. • Run test .• Autocorrelation test investigates whether the returns are statistically independent of each other i. Filter rules should not work if markets are weak form efficient. • Filter rule is a trading rule regarding the actions to be taken when shares rise or fall in value by X%.

• This suggests that prices adjust very rapidly to new information.Semi-Strong Form Market Efficiency • The semi-strong form says that prices fully reflect all publicly available information and expectations about the future. • Most studies find that the markets are reasonably efficient in this sense. • The semi-strong form. repudiates fundamental analysis. • Stock split or announcement of corporate earnings. • Stock price moments during public announcement and after a public announcement is called Event studies. . but the evidence is somewhat mixed. and that old information cannot be used to earn superior returns. if correct.

Tests of the Semi-strong Form • Event Studies – Stock splits – Earnings announcements – Analysts recommendations • Cross-Sectional Return Prediction – Firm size – BV/MV – P/E .

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• Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price. non-public information cannot be used to earn superior results. • Even the knowledge of material.Strong Form Market Efficiency • Security Prices reflect all information—public and private. • Most studies have found that the markets are not efficient in this sense . • Strong form efficiency incorporates weak and semistrong form efficiency.

Mutual Funds. • In fact. . in most years. but mutual funds (and other professionally managed funds) do not.Tests of the Strong Form • • • • Corporate Insiders. Studies have shown that insiders and specialists often earn excessive profits. Specialists. around 85% of all mutual funds underperform the market.

Relationship among Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices .

– Day of the Week (Monday Effect). – P/E Effect. .Anomalies • Anomalies are unexplained empirical results that contradict the EMH: – The Size effect. – The “Incredible” January Effect.

The Size Effect • Beginning in the early 1980’s a number of studies found that the stocks of small firms typically outperform (on a risk-adjusted basis) the stocks of large firms. • This is even true among the largecapitalization stocks within the S&P 500. . The smaller (but still large) stocks tend to outperform the really large ones.

.The “Incredible” January Effect • Stock returns appear to be higher in January than in other months of the year. • It may also be related to end of year tax selling. • This may be related to the size effect since it is mostly small firms that outperform in January.

• This may be related to the size effect since there is a high correlation between the stock price and the P/E.The P/E Effect • It has been found that portfolios of “low P/E” stocks generally outperform portfolios of “high P/E” stocks. • It may be that buying low P/E stocks is essentially the same as buying small company stocks. .

this effect disappeared completely and Monday became the best performing day of the week between 1989 and 1998. rather than just one day.The Day of the Week Effect • Based on daily stock prices from 1963 to 1985 Keim found that returns are higher on Fridays and lower on Mondays than should be expected. • Moreover. . after the stock market crash in 1987. • This is partly due to the fact that Monday returns actually reflect the entire Friday close to Monday close time period (weekend plus Monday).

• Semi-strong form is mostly supported . • Ultimately. . so fundamental analysis cannot consistently outperform the market. • Strong form is generally not supported. though not perfectly efficient. so technical analysis cannot consistently outperform the market. It is unlikely that any system of analysis could consistently and significantly beat the market (adjusted for costs and risk) over the long run.Summary of Tests of the EMH • Weak form is supported. you CAN use it to earn excess returns on a consistent basis. If you have secret (“insider”) information. most believe that the market is very efficient.

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Random Walk Theory and Efficient Market Hypothesis (EMH) .

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