EFFICIENT MARKET HYPOTHESIS

EMH
Assumptions:
Market efciency assumes that a large number of proft maximizing
participants are analysing and valuing securities independent of each
other.
Market efciency assumes that new information comes to the market in a
random fashion and that the timing of news announcements are
independent of each other.
Investors adjust their estimate of security prices rapidly to refect their
interpretation of the new information received. However, market efciency
does not assume that market participants correctly adjust prices, just that
their price adjustments are uniased. !o, some will over adjust and some
will under adjust. "i.e. errors in market price are random#
The Theory:
$n efcient capital market is one where the current price of a security fully
refects all the information currently availale aout that security, including
risk.
$n informationally efcient capital market is one in which security prices
adjust rapidly to new information.
Implication:
There is no possibility that we can consistently make an abnormal
return based on the publicly available information.
In an efcient market, the e%pected returns from any investment will e
consistent with the risk of that investment over the long term, though there
may e deviations from these e%pected returns in the short term.
Note:
Market price is an uniased estimate of the true value of the investment
&his does not re'uire the market price to e e'ual to true value at every
point in time
&his re'uires that the errors in market price e random "uniased#
THREE FORMS OF EMH
&he Wea!Form EMH assumes that current stock prices fully refect all
currently available security market information (historical information).
&hus, info like past price and trading volume will have no relationship with the
future direction of security prices.
If the weak form of the (MH holds, then investors cannot achieve e%cess
returns using technical analysis.
&he Semistrong!Form EMH asserts that security prices adjust rapidly to the
release of all new pulic information. &hus current security prices fully refect all
market and non-market public information.
If the semistrong form of the (MH holds, then investors cannot achieve
e%cess returns using fundamental analysis.
&he Strong!Form EMH asserts that stock prices fully refect all information from
pulic and private sources. &he strong form includes all types of information:
market non-market public and private (inside) information. &his means
that no group of investors has monopolistic access to information relevant to the
formation of prices.
If the strong form of the (MH holds, then no group of investors should e
ale to consistently achieve e%cess returns.
Norman Cheung EMH 1
RO"E OF #ORTFO"$O M%&%'ER
If security markets are completely efcient, portfolio managers will not e ale
to earn aove)market returns. In this case, the portfolio manager has several
responsiilities. *irst, the portfolio manager should seek optimal
di(ersifcation while minimi+ing transaction costs. !econd, the portfolio
manager should help clients understand and 'uantify their ris tolerances and
return needs. *inally, the portfolio manager should monitor bot) t)e clients*
needs and circumstances and changes in the capital markets.
In other words, portfolio managers must try to create,maintain a proper mi% of
assets to meet their client-s needs. Managers should always focus on the
minimi+ation of transaction costs, ta%es, and li'uidity costs.
&E+ESS%R, +O&-$T$O&S FOR M%R.ET EFF$+$E&+,
It is the actions of investors, sensing argains and putting into e.ect schemes to
eat the market, that make the markets efcient
&he necessary conditions for a market inefciency to e eliminated are:
o &he market inefciency should provide the asis for a scheme to eat the
market and earn e%cess return. *or this to hold:
/. the assets"s#, which is the source of inefciency, has to e
traded
0. transaction costs of e%ecuting the scheme have to e smaller
than the e%pected pro1ts from the scheme
o &here should e pro1t ma%imising investors who
/. recognise the potential for e%cess return
0. can replicate the eat the market scheme that earns e%cess
return
2. have resources to trade on the stock until the inefciency
disappears
o Internal contradiction
no possiility to eat the market in (M
re'uire investors to seek ways to eat the market and thus
make it efcient
if markets are efcient, investors will stop looking for
inefciencies, leading to markets ecoming inefcient again 3
o !elf)correcting mechanism
inefciencies appear at regular intervals ut disappear almost
instantaneously when found and traded on.
F/RTHER $&TER#RET%T$O&
&he e0cient maret )1pot)esis 2EMH3 states that:
4securit1 prices full1 re5ect all a(ailable information6
o 4availale to the market ,pulic4 means that it must e accessile to
all
o &his is a very strong hypothesis as it refers to all information. It is
therefore very hard easy to refute, as you only need to 1nd one
e%ample.
4securit1 prices alwa1s e7ual fundamental (alue6
o fundamental to the market ut not to insiders
*ormally: ("5
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# 7 ("5
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where ("5
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# 7 information set used y the market
("5
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# 7 speci1c information placed into the pulic
Norman Cheung EMH 2
domain.
It implies:
- there is no possiility that we can consistentl1 make an anormal
return ased on the pulicly availale information.
- if there is information put into the pulic domain that has not yet een
used y the market and has not yet een refected into the price, then
there is an opportunity for investors to make an anormal return
"provided the transaction costs are smaller then the anormal returns#.
!ore "#A info $ materials can be retrieved from the followin%s:
For visitors from Hong Kong: http://normancafe.uhome.net/StudyRoom.htm
For visitors outside Hong Kong: http://www.angelfire.com/nc3/normancafe/StudyRoom.htm
Norman Cheung EMH 3