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NPTEL Course

Course Title: Security Analysis and Portfolio Management


Course Coordinator: Dr. Jitendra Mahakud
Module-4

Session-7
Efficient Market: Concepts and Forms of Market efficiency

7.1. Market Efficiency


In capital markets an investors expectation of return is driven by the approach for
making excess profit than to other potential investment options. This leads to the
fundamental premise of an investment is expect higher return on higher risk. However
when academic literature attempts to define market efficiency, it emphasises that is a
market is efficient, then the market price is the true and unbiased estimate of the true
value of investment. In other words a market can be categorised as efficient on the basis
of its informational efficiency. If capital markets are efficient enough then all the relevant
information is impounded into the stock price and the quoted stock prices always
incorporate and reflect all relevant information. Under such conditions the investors are
unable to beat the market with supernormal profit. Therefore, if a market is categorised as
efficient with respect to information set it, then it is impossible for the market participants
to make economic profits by trading on the basis of information set it. It can be also being
considered as a zero profit competitive equilibrium condition with respect to the dynamic
price behaviour of securities under conditions of uncertainty.

7.2. Conditions of Market Efficiency


The market in which the price for any security effectively represents the expected net
present value of all future profits can be characterised as efficient market. To say market
is efficient is access the speed at which new information filters into the price. However
the scenario of efficient market and different degree of market efficiency depend upon
the following conditions:

a large number of competing profit-maximizing participants analyse and value


securities, each independently of the others

active participation in the market

individuals can not affect the market prices

information must be free

free entry and exit by market players must be uninhibited


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7.3. Efficient Market Hypothesis


According to Efficient Market Hypothesis (EMH) successive absolute short run price
changes are independent. It signifies how quickly and accurately does relevant
information have its effect on the asset prices.
It states that the current prices of securities reflect all information about the
security (Random Walk Hypothesis). New information regarding securities comes to the
market in random fashion profit-maximizing investors adjusts security prices rapidly to
reflect the effect of new information. This includes information about confidence
amongst investors and consumers, as well as information regarding the likelihood of
future events. The expected returns implicit in the current price of a security should
reflect its risk (Fair Game Model). Depending up on the degree of efficiency of a market
or a sector thereof, the return earned by an investor will vary from the normal return
(return appropriate to risk level).
Efficient market is one where the market price is an unbiased estimate of the true
value of the investment. As per the efficient market share prices are correct at all times
i.e., the essence of a correct price is not that it predicts the future, but that it fully captures
the uncertainties of the future.1

7.4. Different Types of Efficient Market Hypotheses2


Market efficiency is usually analyzed by addressing two questions: first can the market
be predicted? and secondly are there strategies that beat the market? If the market can
be predicted and there are strategies available to beat the market, then the basic tent of
market efficiency hypothesis can never be accepted. Several versions of the Efficient
Market Hypothesis have been widely discussed and tested in the literature. The
differences revolve primarily around the definition of the information set used in those
tests. In his original article, Fama (1970)3 divided the overall efficient market hypothesis
(EMH) and the empirical tests of the hypothesis into three sub hypotheses depending on

Brodie
Niamh
and
Sophister,
J.
www.tcd.ie/Economics/SER/sql/download.php?key=220
2

Speculative

Bubble,

Irrationality

and

Chaos,

Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western.

Eugene F. Fama (1970) , Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, Vol. 25, No. 2,
pp. 383417.

the information set involved: (1) weak-form EMH, (2) semi strong-form EMH, and (3)
strong-form EMH.

Weak form of market efficiency: Prices reflect all information contained in past
prices and returns (rules out technical analysis). Assumes that current stock prices
fully reflect all security market information, including the historical sequence of
prices, rates of return, trading volume data, and other market-generated
information, such as odd-lot transactions, block trades, and transactions by
exchange specialists. In other words, the information set t is taken to be solely
the information contained in the past price history of the market as of time t and
past rates of return and other historical market data should have no relationship
with future rates of return.

Semi-strong form of market efficiency: Prices reflect all public information


(past prices, news papers contents, databases, etc.). It asserts that security prices
adjust rapidly to the release of all public information; that is, current security
prices fully reflect all public information. In this case It mistaken to be all
information that is publicly available at time t. This also includes the past history
of prices so the weak form is just a restricted version of this.

Strong form of market efficiency: Prices reflect all available information, both
public and private. This means that no group of investors has monopolistic access
to information relevant to the formation of prices. Therefore, no group of
investors should be able to consistently derive above-average risk-adjusted rates
of return. In this case It is taken to be all information known to anyone at time t.

7.5. Implications of Efficient Market Hypothesis

For professional money managers


Less time spent on individual securities
Passive investing favoured
Otherwise must believe in superior insight
Tasks if markets informationally efficient
Maintain correct diversification
Achieve and maintain desired portfolio risk
Manage tax burden
Control transaction costs

_______________________________________________________________________

Additional Readings:

Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V.,


Fundamentals of Investment, 3rd Edition, Pearson Education.
Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. Investments, 6th Edition,
Tata McGraw-Hill.
Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th
Edition, Tata McGraw Hill (India).
Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th
Edition., Prentice-Hall.
Fama Eugene F. (1991), Efficient Capital Markets: II, Journal of Finance, Vol.
46, No. 5, PP. 15751617.
Jones, Charles, P., Investment Analysis and Management, 9th Edition, John
Wiley and Sons.
Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata
McGraw-Hill.
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management,
7th Edition, Thomson Soth-Western.

Additional Questions with Answers


Session-7- Efficient Market: Concepts and Forms of Market efficiency

_________________________________________________________
1. What is Market Efficiency and Conditions of an Efficient Market?
Ans.
Issues in Efficient Market
Markets respond to new information
Possible to distinction for a decision between a profitable and unprofitable
investment given current information
Types of Efficiency: Operational efficiency, Informational efficiency (efficient
market hypothesis)
Conditions of an Efficient Market:
A large number of competing profit-maximizing participants analyze and value
securities, each independently of the others
Active participation in the market
Individuals can not affect the market prices
Information must be free
Free entry and exit by market players must be uninhibited
2. Explain Efficient Market Hypothesis?
Ans.
Efficient Market: The market in which the price for any security effectively
represents the expected net present value of all future profits.Buying or selling the
stock should, on average, return you only a fair measure of return for the
associated risk.
Types of Efficiency: Operational efficiency, Informational efficiency (efficient
market hypothesis)
Conditions of an Efficient Market:
4

A large number of competing profit-maximizing participants analyze and value


securities, each independently of the others
Active participation in the market
Individuals can not affect the market prices
Information must be free
Free entry and exit by market players must be uninhibited
Efficient Market Hypothesis
The current prices of securities reflect all information about the security (Random
Walk Hypothesis)
New information regarding securities comes to the market in a random fashion
Profit-maximizing investors adjust security prices rapidly to reflect the effect of
new information. The expected returns implicit in the current price of a security
should reflect its risk (Fair Game Model)
3. What are the different forms of Market Efficiency?
Ans.
Efficient market hypothesis: To what extent do securities markets quickly and fully
reflect different available information?
Three levels of Market Efficiency
I.
Weak form - prices reflect all security-market information
Current prices reflect all security-market information, including the historical
sequence of prices, rates of return, trading volume data, and other marketgenerated information
This implies that past rates of return and other market data should have no
relationship with future rates of return
Technical analysis, which relies on the past history of prices, is of little or no
value in assessing future changes in price
II. Semi strong form - prices reflect all public information
Current security prices reflect all public information such as earnings, stock
and cash dividends, splits, mergers and takeovers, interest rate changes etc. It
also says that prices adjust to such information quickly and accurately so
abnormal profits on a consistent basis can not be earned.
This implies that decisions made on new information after it is public should
not lead to above-average risk-adjusted profits from those transactions
III. Strong form - prices reflect all public and private information
Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive
above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and
available to everyone at the same time
4. What is the Implications of Efficient Market Hypothesis for investment decisions?
Ans. Implications of Efficient Market Hypothesis
For investors:
Technical analysis is no valuable if weak form holds
Fundamental analysis of intrinsic value will be of no use if semi strong form holds

For professional money managers


Less time spent on individual securities: Passive investing favored, Otherwise
must believe in superior insight
Tasks if markets informationally efficient: Maintain correct diversification,
Achieve and maintain desired portfolio risk, Manage tax burden, Control
transaction costs