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CHAPTER 3 EFFICIENT MARKET HYPOTHESIS

Wan Nurul Basirah Wan Mohamad Noor © | Faculty of Accountancy | UiTM Cawangan Kelantan
LEARNING OUTCOMES
At the end of this chapter, student should be able to:
• Explain the concept of capital market efficiency
• Define and explain the three forms of efficiency
• Describe the various empirical tests (evidences) of market efficiency
• Explain the implications of efficiency for corporate finance managers

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O2
Basic stock investment is a game of good news vs bad news.

It means that the good or bad news regarding the

particular company are directly related to its stock price.

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If the sales reports are good, But if the sales reports of
then theoretically the share a company are bad, then its
price is expected to go up. share price will goes down.

O3
 Bill buys the shares of BAE
before the news about the
great sales being
Bob, the CEO of BAE Ltd, announced to the public.
reviews the latest
company’s sales report Bob tells the news Bob then decides to
and he sees that the to his bfftj, Bill. announce the news to the
company is doing great. public, and as expected the
share price of BAE goes up!

How might people earn money using the news?

What happen to Bill?
Bill gets rich quick because he
bought the shares before the
announcement – he got to buy the
share at a much cheaper price!
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Grandma is interested to buy the share of
BAE after she heard the announcement.
What happen to Grandma?
Grandma did not get rich quick
because she heard the news after
the share price goes up and Bill
already made money on it.

O4
A financial market is efficient
if the prices always fully reflect
all the available information.

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Eugene Fama (1970)

O5
EFFICIENT MARKET
HYPOTHESIS
• An efficient capital market is a capital market in which stock prices
fully reflect available information.
• The news spreads very quickly and is incorporated into the prices
of securities without delay.
• EMH reckons that investors quickly incorporate all available
information when making the decision on the correct share price

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at which they are willing to trade.
• Due to competition among investors, when new information becomes
known, the share prices adjust immediately and accurately.
• Hence, it is impossible for investors to consistently outperformed the
market by purchasing undervalued stocks or selling overvalued stocks.
O6
 Suppose Astro Zinika is attempting to develop an antiviral pills for
Covid-19 that will reduce the risk of patients progressing to severe
disease, including hospitalization and death.
• One important factor is the probability that AZ will be the first company to
develop the pills and currently there is no clinically-tested cure for Covid-19.
• In an efficient market, we would expect the price of the shares of AZ to
increase if this probability increases.

When will the increase in the price of AZ’s shares occur?

• Assume that the announcement is made in a press release on Tuesday

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morning.
• In an efficient market, the shares prices in AZ will immediately adjust to this
new information.
• Investors should not be able to buy the stock on Tuesday afternoon (while
the stocks are still cheaper) and make a profit on Wednesday.

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STOCK PRICE
REACTION
Good news Bad news

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 FEATURES OF
EFFICIENT MARKET
Rational investors
Many knowledgeable Availability of information
investors actively analyzing,
valuing and trading. Information is widely available and nearly free.

Investors react quickly and
accurately to new information,
causing the prices to adjust
immediately and therefore are
always at their fair value.
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Information on firm’s unique events like labour strike,
changes in product demand and etc tends to
emerge randomly.

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 FORMS OF
EFFICIENCY

Efficiency level weak semi-strong strong

past past + public past + public

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+ private

Types of Information set of Information set of All information relevant

information that the past prices of a stock publicly available to a particular stock
share prices reflect information of a stock
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WEAK EFFICIENCY
• Share prices fully incorporate all historical financial share
price movements.
• It holds that past data of share prices does not have any
value in predicting future changes in prices.
• Since share prices move randomly and that new information
arrives unexpectedly, stock prices are said to follow a random
walk model.

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• If the weak form of market efficiency holds, then technical
analysis that study past price movements will not give any
advantage to the investors.
• If it were possible to make extraordinary profits simply by
finding patterns in share price movements, everyone would
do it and any extra profits would disappear.

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WEAK EFFICIENCY
TEST OF THE WEAK FORM EFFICIENCY
• A serial correlation test analyze the correlation between past returns and the
current returns of the same share.
• The findings will indicate whether there is a relationship between the current returns
of a security and its past returns.
• A positive coefficient of serial correlation for a particular stock indicates tendency

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towards continuation (if yesterday’s return higher, today’s return also higher).
• A negative coefficient indicates tendency towards reversal (if yesterday’s return higher,
today’s return will be lower).
• Findings from previous research showed a very low correlation between past and
current returns of the security, which is strongly consistent with weak-form efficiency.

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SEMI-STRONG EFFICIENCY
• Share prices reflect all relevant information about past price movements and
publicly available knowledge.
• This form of the market shows that share prices reflect both:
• All relevant information about past price movements
• All publicly available information

• If the market is semi-strong efficient, investors cannot

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consistently beat the market by studying economic figures
from the annual reports, magazines, news or social medias.
• The response from the investors towards this information
allows the market to update itself very quickly.
• Semi-strong efficiency implies that most
fundamental analyses are useless.
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SEMI-STRONG EFFICIENCY
TEST OF THE SEMI-STRONG FORM EFFICIENCY
• An event studies examine whether the release of information influences returns
on other days.
• A stock split is a corporate action in which a company increases the number of its
outstanding shares by issuing more shares to current shareholders. After a split, the
stock price will be reduced because the number of shares outstanding has increased.

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• The research found that share prices rose sharply before the stock split, but the
changes after the event are random.
• Buying the shares during or after the announcement will not benefit the investors
because the market had already incorporated the favorable information related to the
stock split into the price by the time of the announcement.
• Therefore, it is consistent with the semi-strong form of efficiency.
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STRONG EFFICIENCY
• Share prices reflect all relevant information about past
price movements, publicly available knowledge and
inside knowledge.
• Strong form efficiency says that anything pertinent to
the shares and known to at least one investor is already
incorporated into the share prices and hence, there is
no such thing as secret.

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• This implies that prices incorporate even the information
that has not been publicly available.
• If market is in a strong form of efficiency, even insider
information will not become advantageous to investors
because that information has already been accounted
for in the market.
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STRONG EFFICIENCY
TEST OF THE STRONG FORM EFFICIENCY
• One group of studies investigate whether trading on inside information
can generate extra profit.
• Insiders in firms have access to information not generally available and these
trades were abnormally profitable.
• Empirical research has confirmed that those with inside information do have the

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opportunity to earn abnormal returns.
• Thus, strong-form efficiency hypothesis does not seem to be supported by the
evidences.

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SUMMARY OF
MARKET EFFICIENCY
WEAK SEMI-STRONG STRONG

Market prices reflect Market prices reflect Market prices reflect

information contained past data and public all information,
in historical prices. information. public or private.

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Investors are unable to Investors trying to predict Investors are still unable
earn abnormal returns future price with past & to earn abnormal returns
using historical prices to publicly-available even when using insider
predict future price information are unable to information to predict
movements. earn abnormal returns. future price movements.

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MARKET EFFICIENCY FORMS
AND THE INVESTORS’ ABILITY IN EARNING
A CONSISTENT ABNORMAL RETURNS

Types of WEAK SEMI-STRONG STRONG

information

Past No No No

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Public Yes No No
Private Yes Yes No

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ILLUSTRATION 1
For each scenario below, provide arguments to explain whether the stock market is
efficient or not. If you think it is efficient, indicate the most likely level of efficiency.

1. Sam, a former stock broker, has developed an advanced computer model to analyze
historical stock prices. He claims to have earned consistently 5% profit above normal
returns after adjusting for risk.

2. On 19th October 1987, stock markets worldwide crashed. Suddenly and unexpectedly,
for no apparent reason, stocks suffer a drastic fall in price across the board.

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3. Petro Gas Bhd announced this morning that its profit for the last quarter had dropped
20% compared to the previous quarter. But strangely, Petro Gas’ closing price today
went up 10% from yesterday.

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EXERCISES
Which of the following is evidence that the stock market is INEFFICIENT?
Question 1
A. Share price reaction occurs for both good news and bad news.
B. The majority of share price reaction to news occur when the news is announced.
C. Technical analysis is useful.
D. Attempting to trade on consistently repeating patterns is unlikely to work.

Kim does not believe there is any value to be had in reading the newspaper to help him
Question 2 formulate an investment strategy for his share portfolio. He believes that having inside
information can help him make abnormal return.

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How efficient does Kim believes the capital markets are?
A. Not efficient at all
B. Weak form efficient
C. Semi-strong efficient
D. Strong form efficient

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EXERCISES
Question 3 Which of the statements is TRUE?
A. The random walk theory is based on the idea that past share price patterns will be repeated.
B. Under weak form hypothesis of market efficiency, share prices reflect all available information
about past price changes in share price.
C. If a stock market displays semi-strong efficiency, then individuals can beat the market.
D. In a strong form efficient market, an insider or company’s officer can outperform other
investors by trading on the inside information.

Question 4 After careful analysis, Miss Joy discovers that she can make abnormal returns on her investments

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if she buys health care stocks early in the morning and then sells them shortly before the market
closes that day.
This is a violation of ______ market efficiency.
A. all forms of
B. semi strong form
C. weak form
D. strong form
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EXERCISES
Question 5 Which form of efficient market maintains that all information is already incorporated into the
value of a security?
A. Weak form
B. Semi strong form
C. Strong form
D. All forms

Question 6 Which of the followings is TRUE?

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A. In an efficient market, the concept of “dart throwing” is applicable; investors can just choose
any stock to invest in since all shares are correctly priced.
B. Strong form efficiency also implies semi-strong and weak form efficiency.
C. In an inefficient market, an investor can only make abnormal return if he or she has access to
inside information.
D. Daily movements or fluctuations in stock price indicate that the market is inefficient.

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EXERCISES
Assume the stock market is semi-strong form efficient. Explain whether there is
Question 7 a possibility that you would earn abnormal return if you trade based on the
following information:

1. There is a cyclical pattern in a company’s share price movement in which the price will
gradually increase for two weeks and then drops sharply at the end of the second week.

2. A friend informed you that his company is making a major discovery that will benefit
mankind. An official announcement will be made by the CEO of the company in the
following week.

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3. The press statement of a public listed company announces that the company’s current
year profit has increased by 75% from the previous year.

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EMH IMPLICATION
FOR CORPORATE FINANCE
Accounting Choice
• The accounting profession provides firms with a significant amount of
leeway in their reporting practices.
• Managers clearly prefer high stock prices to low stock prices, therefore
they tend to use the leeway in accounting choices to report the highest
possible income.

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• Under EMH, the price of a company’s share prices cannot be affected by
a change in accounting.
• Enough information must be provided in the annual report so that financial
analysts can construct earnings under the alternative accounting methods.
• The market must appropriately use all of this accounting information in
determining the market price.
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EMH IMPLICATION
FOR CORPORATE FINANCE
Timing Decision
• Imagine a firm whose managers are contemplating the date to issue
equity. This decision is frequently called the timing decision.
• If managers believe that their stock is overpriced, they are likely to issue
equity immediately.

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• Conversely, if the managers believe that their stock is underpriced, they
are more likely to wait, hoping that the stock price will eventually rise to
its market value.
• Under EMH, securities are always correctly priced because efficiency
means that stock is sold for its true worth, so the timing decision
becomes unimportant.

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EMH IMPLICATION
FOR CORPORATE FINANCE
Speculation
• Many companies make interest rate bets, where if the managers believe
that interest rates are likely to rise, they have an incentive to borrow
because the present value of the liability will fall with the rate increase.
• Suppose the CEO of a multinational company based in US believes that
the euro will decline relative to the dollar.

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• She would probably issue euro-denominated debt rather than dollar-
denominated debt because she expects the value of the foreign liability to fall.
• Under EMH, managers should not waste their time trying to forecast the
movements of interest rates and foreign currencies because their forecasts will
likely be no better than chance.

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