VIDYASAGAR UNIVERSITY

DIRECTORATE OF DISTANCE
EDUCATION
MIDNAPORE-721102

M.Com.
Part – II
Paper: DCOM 201 SLM No: 053

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 VIDYASAGAR UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
VARIOUS FORMS OF MARKET EFFICIENCY
SLM NO - 53
PAPER CODE: DCOM 201
PAPER NAME: SECURITY ANALYSIS AND PORTFOLIO
MANAGEMENT

Structure
Objectives
Relevance of the Unit
53.1 Introduction
53.2 Principles of EMH
53.3 Different types of market efficiency
53.3.1 Weak form of market efficiency
53.3.2 Semi-strong form of market efficiency
53.3.3 Strong form of market efficiency
53.4 Random walk theory
Summary
Glossary
Self-assessment Questions
References

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Objectives
After reading this unit the learners will be able to:
• Understand the efficient market hypothesis
• Understand the different forms of market efficiency
• Understand the random walk theory

Relevance of the Unit

This is a very relevant and useful topic under the subject Security Analysis and Portfolio
Management. This unit covers a number of important theoretical aspects like the concept of
Efficient Market Hypothesis, types and related theories etc. which would be highly useful for the
students of commerce.

53.1 Introduction
The efficient market hypothesis is a very important development in the field of finance. The
basic principle of the theory is that the current market price of securities is reflective of all
information that is available at that point of time. Consequently, there is no way by which a new
price discovery can be made by somebody else in the market. In other words, it is no way
possible to make abnormal profit in such a situation. Hence, there is no scope of arbitrage as all
information is already factored into the security price. The theory, however, does not say that
investors need to be rational. Instead what it believes is that even though some investors might
behave irrationally, the overall market will behave rationally. The EMH believes that all markets
are ‘informationally efficient’ and hence do not give opportunity of earning returns which are in
excess of average returns.
When anybody talks about efficient capital market, he/she wants to say that security prices
reflect all available information. In other words, the price that we see is the intrinsic value of the
security. The hypothesis is connected with the speed of adjustment to existing/new information
that comes in. The technical analyst believes that it is possible to gain more by predicting prices
as there is time span before the adjustment is fully done. In fact, they say that the speed of
adjustment is slow. On the other hand, the fundamentalists believe that the adjustment time
ranges from several days to a few weeks. Thus, it is possible to earn superior returns for
sometime before the adjustment process gets completed.
The EMH states that current price of financial assets reflect all available information. Literature
shows that though the idea had been popularized by Bachelier (1900), the contribution has been
made by Paul A. Samuelson and Eugene F. Fama in the 1960s independently. The term ‘efficient
market’ was first used by Eugene Fama who also mentioned that it is ‘impossible and highly
unlikely’ that it would be possible to predict future prices of securities. It is seen that the focus of
Samuelson was on the pricing models of commodities along with their mechanics of pricing and
linear programming solutions. Fama, on the contrary looked at the statistical properties of stock
prices.

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The ‘random walk’ theory in financial literature is similar to the EMH as it believes that prices
cannot be predicted since the movement of security prices is entirely random in nature. The
direction of movement in the share price is decided solely by any ‘new information’ that comes
into the market. Hence, it is not possible to take advantages of the skill to predict prices as the
ability will not help in reality.

53.2 Principles of EMH

The following are the principles of the Efficient Market Hypothesis -
a) The securities price movement shows a ‘random walk’.
b) Past information has no effect on present price.
c) Price change takes place only due to new information.
d) The new information gets instantaneously reflected in the market with minimum time
gap.
e) Technical analysis does not help in predicting future prices.
f) The fundamentals at the economy level determine and fix the levels of stock prices.

However, it is seen that the practical situation is far away from the optimal position and
accordingly, what we see is not a perfectly efficient market. Instead, there are imperfections to
different extent in different markets. Accordingly, there are three types of market efficiency
which are as follows:
(i) Weak form of efficiency
(ii) Semi-strong form of efficiency, and
(iii) Strong form of efficiency
The basic difference among the three forms of market efficiency is the type of information which
is already incorporated in the market price that is related with the speed of adjustment of new
information to get reflected in the current price. These are discussed in the next section.

53.3 Different Types of Market Efficiency

53.3.1 Weak form of market efficiency

In this form of efficiency, it is believed that the price of securities reflects all past information
which is incorporated therein. Hence, all past information is already factored into the present
market price. This past information is available from different forms of reports that are available
from different websites and are in the public domain. Hence, these sources of information which
are often found in annual reports may help to get higher returns in the short run but will not be
able to generate higher returns in the long-term. In such a form of market, it is not possible to
predict future prices by looking at the prices of the past. In other words, there are no serial
dependencies, thereby pointing to the fact that there is no relation between yesterday’s price and
today’s price. Hence, according to the theory, it will not help investors to study past prices

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because they will in no way help in predicting the future movement of prices. Thus, taking the
help of charts and other tools for technical analysis will not help at all.

As per the theory, it is not possible to earn more than average returns in the long term by the
application of technical analysis. The only input that brings about change in price is new
‘information’ which is not there in the price series. The theory mentions about the randomness in
price behavior. Fama believed that information about security prices is the most easily obtained
and that too at a low cost. Hence, he considered this information as ‘weak’. Thus, in case the
market form is such that it incorporates only the past available information, it is considered to be
a weak form of efficiency.

There are certain tests available to find out whether a market is weakly efficient. Two of the most
popular ones are:
(i) Serial correlation test where a conclusion can be drawn on the basis of correlation between
the successive price changes. A positive figure denotes a positive relationship, minus figure
denotes a negative relationship and a figure of zero points to no relationship.
(ii) Run test which is used to test for the randomness in the movement of stock prices. This test
is a shorter version of the Wald–Wolfowitz runs test, named after two mathematicians
Abraham Wald and Jacob Wolfowitz. The aim of the test is to determine whether the
elements of a given sequence are mutually independent.
(iii) In this test, the absolute value of change is not taken into account. Instead, what is
important is the direction of change. An increase in price is represented by a positive sign
and a decline in price is denoted by a minus sign. No change in price is represented by zero.
A consecutive sequence of the same sign is considered as a run. In this test, the actual
number of runs is compared with the runs in a randomly generated series. If a significant
difference is observed, the securities are considered to be non-random in nature in which it
will be concluded that the weak form of efficiency does not exist in that market.

53.3.2 Semi-strong form of market efficiency

This is the second form of market efficiency. As per this theory, the current price of an asset is
the reflection of all types of past and present information. In other words, whenever there is any
new information that comes into the market, it is instantaneously incorporated into the security
price. Thus, it is not possible to make extra profit in the long-term as it is not possible to take
advantage of any information since it is already public and it has already been absorbed by the
market. By ‘information’, we do not concentrate only on financial statements but any
information that is obtained from published reports, survey reports, investment advisors, media
reports etc. Thus, the effect is already shown on the share price. Thus, as per the theory neither
technical nor fundamental analysis can help in gaining superior returns over others. However, in
such a market, it is possible to earn more returns than others if there is access to ‘insider’
information (also called ‘private’ information). In order to test the semi-strong form of

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efficiency, there are tests to see how fast the public information gets adjusted in the security
prices. If it is fast, then the opportunity to earn superior profits is less and vice-versa.

53.3.3 Strong form of market efficiency

The idea about the strong form of market efficiency was given by Burton G. Malkiel, a Professor
in Economics at the Princeton University in his book titled "A Random Walk Down Wall
Street." which was published in 1973. He elaborated through his writings that it is totally useless
to make estimates about earnings, trace the movement of technical indicators and invest using
advisory services because all kinds of information is already incorporated into the present price.
He suggested that the best idea was to buy and hold as in no way portfolios constructed by
experts will outperform the portfolios created by a ‘blindfolded monkey’. As per this market
efficiency theory, the present trading price is a result of incorporating all kinds of information
which includes past information, present information and insider information. In other words, the
share prices reflect both public and private information. By ‘private information’, we mean that
information which is available only to a few ‘private’ individuals who are close to the key
decision-makers of the company (i.e. insider information). By key personnel for a company, we
mean any Director or person of senior management level. Hence, it is not in any way possible to
earn profits higher than the average return. This is, therefore, the most stringent form of market
which does not provide opportunities to continue to earn more in the short term.
In order to test whether a market is having strong form of efficiency or not, two types of tests are
available. The first types of tests aim to find whether the people who have access to the ‘private’
information are actually able to earn more returns than others. The second types of tests aim to
find out whether it is possible to earn better returns on the basis of advice given by investment
advisory firms and other brokerage firms.

Check your progress

Q1: What do you understand by ‘private’ information?

Q2: Explain the different forms of market efficiency.

53.4 Random Walk Theory

This theory in the literature of finance is very well connected to the efficient market hypothesis.
According to the theory, the movement of share prices is totally abrupt and ‘random’ in nature.
In other words, the movement of security prices can very well be compared to the walking style
of a drunkard on a street where it is not possible to predict the direction and position of the next
footstep. In other words, the theory suggests that it makes no sense to study the past prices as the
movement of prices in the future cannot be predicted. This is because the change in price takes
place only on account of new information that comes into the market. On the receipt of new

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information, there is a rapid shift in the price to a new level which can be on the upper side or
lower side. After the change, the price continues to move at that level. Again, there will be a
change only after new information is received by the market. Thus, it is these pieces of
information that are the drivers of prices of securities. Today’s price is independent of
yesterday’s price because they are not related.
The Random Walk theory is based on some assumptions:
(i) There are no restrictions on trade.
(ii) The market has a mechanism by which information is absorbed almost instantaneously.
(iii) The information that is available is unbiased and correct.
(iv) The information is free and is available to all at no cost.
(v) Demand and supply forces act very fast in order to bring adjustment to the share price.

The basic assumption of the theory is that all investors have full information about the economy,
industry and the company. Whenever, any news comes in, it is instantly adjusted to the prices
and the price moves upwards or downwards. Hence, yesterday’s price does not have any impact
on today’s price. Consequently, the prices are independent of one another. Hence, it is clear that
the random walk theory follows the same line as a strongly efficient market hypothesis. In fact, it
assumes that the stock markets are efficient due to which it later on came to be known as the
efficient market hypothesis.
The problem with the theory is that it does not consider trends which can be observed easily and
also those factors that have an effect on the movement in prices. The practical implication of the
theory is that in the short-term simply timing the market and making efforts to take buying and
selling decision will ultimately not help as the share price movement is random. A buy and hold
strategy will be equally effective for investors.

Check your progress

Q1. Discuss the Random Walk Theory with regard to movement of security prices.

Summary

The module covers the concept of efficient market hypothesis. It also discusses the different
forms of market efficiency apart from the Random Walk Theory.

Glossary

• Weak form of market efficiency: The current share price has already incorporated all past
information.

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• Semi-strong form of market efficiency: The current price is reflective of all past and
publicly available information.

• Strong form of market efficiency: The present price is reflective of all past information,
presently available ‘public information’ and ‘private’ (also called insider information).

• Random walk theory: The theory says that share prices cannot be predicted as they follow
a random walk. The prices change only as a result of new information that comes into the
market.

Self-assessment Questions

Q1. Explain the Efficient Market Hypothesis.

Q2. Discuss the Random Walk Theory.

Q3. Explain the different forms of market efficiency.

References

a. Francis, J. C.: Management of Investments, McGraw Hill, N.Y.

b. Fischer, D. E. and Jordan, R. J.: Security Analysis and Portfolio Management, Prentice
Hall, N. Delhi.
c. Fuller, R. J. and Farrell Jr., J. L.: Modern Investments and Security Analysis, McGraw-
Hill, Singapore.
d. Raghunathan, V., Barua, S. K. and Verma, J.: Portfolio Management, TMH, N. Delhi.
e. Fabozzi, Frank J.: Investment Management, Prentice Hall, International Edition.
f. Kevin, S. : Portfolio Management, PHI, N. Delhi.
g. Pandian, P.: Security Analysis and Portfolio Management, Vikas Publishing House Pvt.
Ltd., N. Delhi.
h. Ranganatham, M. and Madhumati, M.: Security Analysis and Portfolio Management,
Pearson.

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