CHAPTER 4:

EFFICIENT MARKET
Jabatan Perdagangan

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CONTENT OUTLINE
1) Definition of efficient market hypothesis (EMH)
2) Economic conditions cause market efficiency
3) Level of market efficiency
4) Reason the market efficiency difficult to test

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Definition of Efficient Market Hypothesis
(EMH)
The main implication of an
Efficient Market Hypothesis is a
Conceptually, EMH is defined as efficient market is that investors
theory that financial markets are
one where prices of all securities will not be able to consistently
informationally efficient and
quickly and fully reflect all earn abnormal profits based on
should therefore move
available relevant information. the information that they use to
unpredictably.
make their investment decisions.

Therefore, it should be
According to the EMH, stocks
impossible to outperform the
always trade at their fair value on
overall market through expert
exchanges, making it impossible
stock selection or market timing,
for investors to purchase *A hypothesis is
and the only way an investor can a proposed
undervalued stocks or sell stocks
obtain higher returns is by explanation for a
for inflated prices. phenomenon.
purchasing riskier investments.

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Efficient Market Example
• Fatimah holds 850 shares of a technology company that currently trade at
RM125.36 per unit. Her best friend, who is an insider in the company, informs
Fatimah that the stock price will decline over the next days because the company
has failed in a project.
• Fatimah does not believe her friend and holds all his shares. A week later, the
company announces the failure of the deal, and the stock price starts declining
sharply, dropping to RM105.12 in a couple of days.
• The market is efficient and adjusts immediately to the newly available information
– in this case, the company’s announcement about the failed deal.
• To realize a gross gain, Fatimah should have sold some of her shares at RM125.36
per unit as soon as the market adjusted to the newly available information.
Instead, she held all her shares, thus losing money. If she had sold 400 shares at
RM125.36 per unit, she would realize a gross gain of RM50,144 (400 x RM125.36).
Now that she held all her 850 shares, her loss is RM17204 [(850 x RM125.36) –
(850 x RM105.12)].

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Assumption in Efficient Market

Investors analyze
Investors act
information in the
rationally.
same way.

Share are always

Share prices reflect
trading at their
all information,
current fair market
instantly.
value.

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Economic Conditions Cause Market Efficiency

1) Investor Rationality

2) Independent Deviations From Rationality

3) Arbitrage

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Economic Conditions Cause Market Efficiency
– Con’t
• Investor Rationality

If that so, share price

When new information
will react accordingly Thus, the prices of all
is released in the
with the relevant securities are
market, all investors
information. Good completely fair and
will adjust their
news led to increasing reflect an asset’s
estimates of stock
the share value while intrinsic value at any
prices in a rational
bad news will decrease given time.
way.
the share value.

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Economic Conditions Cause Market Efficiency
– Con’t
• Independent Deviations From Rationality

Suppose that many

investors were irrationally
Due to emotional
optimistic as were
resistance, investors could Thus, market efficiency
irrationally pessimistic,
just as easily react to new does not require rational
prices would likely rise in a
information in either individuals – only
manner consistent with
irrational pessimistic or countervailing
market efficiency, even
irrational optimistic irrationalities.
though most investors
manner.
would be classified as less
than fully rational.

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Economic Conditions Cause Market Efficiency
– Con’t
• Arbitrage

Arbitrage is the An efficient market The moment an

strategy of taking always allocates funds arbitrage opportunity
advantage of price to their most presents itself, the
differences in different productive use. This is potential arbitrageurs
markets for the same achieved through respond with
asset. EMH is true if the competition among transactions that
market is free of wealth maximizing remove it from the
arbitrage opportunities. investors. marketplace.

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Level of Market Efficiency

1) Capital Weak Form

2) Semi-Strong Form

3) Strong Form

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 Level of Market Efficiency – Con’t

Capital Weak Form

It additionally assumes Therefore, technical

Assumes that the prices of
that future securities' trading strategies cannot
securities reflect all
provide consistent excess
available public market prices are random and not
influenced by past returns because past price
information but may not
information regarding performance can’t predict
reflect new information
that is not yet publicly price, volume, and returns. future price action that will
be based on new
available.
information.

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Level of Market Efficiency – Con’t
EXAMPLE OF CAPITAL WEAK FORM

• Suppose Ms Zainab a trader, sees Axiata Group Berhad (AXIATA) continuously

decline on Mondays and increase in value on Fridays.
• She may assume she can profit if she buys the stock at the beginning of the
week and sells at the end of the week.
• If, however, Axiata’s price declines on Monday but does not increase on Friday,
the market is considered weak form efficient.

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 Level of Market Efficiency – Con’t

Semi-Strong Form
It contends that
security prices have Only material
It concludes that
factored in nonpublic
Assumes that neither
publicly-available information would
current stock prices fundamental nor
market and that benefit investors
adjust rapidly to the technical analysis
price changes to seeking to earn
release of all new can be used to
new equilibrium above average
public information. achieve superior
levels are returns on
gains.
reflections of that investments.
information.

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Level of Market Efficiency – Con’t
EXAMPLE OF SEMI STRONG FORM

• Suppose stock Tenaga Nasional Berhad is trading at RM10, one day before it is
scheduled to report earnings.
• A news report is published the evening before its earnings call that claims TNB’s
• business has suffered in the last quarter due to adverse government regulation.
• When trading opens the next day, TNB's stock falls to RM8, reflecting movement due
to available public information.
• But the stock jumps to RM11 after the call because the company reported positive
results on the back of an effective cost-cutting strategy.
• The managerial nonpublic information, in this case, is news of the cost-cutting
strategy which, if available to investors, would have allowed them to collect profit.

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 Level of Market Efficiency – Con’t

Strong Form

Even information not

Assumes that prices always Therefore, not even insider
publicly available to
reflect the entirely of both knowledge can give
investors, such as private
public and private investors a predictive edge
information known only to
information; includes all that will enable them to
a company’s CEO, is
publicly available consistently generate
assumed to be always
information, both returns that outperform
already factored into the
historical and new, as well the overall market
company’s current stock
as insider information. average.
price.

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Level of Market Efficiency – Con’t
EXAMPLE OF STRONG FORM

• A head marketing director of Nestle (Malaysia) Berhad believes that his firm will
begin to lose customers and revenues.
• After the internal rollout of a new product feature to testers, his fears are
confirmed, and he knows that the official rollout will be a flop. This would be
considered insider information.
• Accordingly, he expect that the stock price will decline consistent with the product
failure.
• However, when the product feature is released to the public, the stock price is
unaffected and does not decline even though customers are disappointed with
the product.

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 Level of Market Efficiency – Con’t
All available public
information • In the diagram, the
Strong-form circles represent the
amount of information
that each form of EMH
Both public and includes
private • Note that the weak form
information Weak
cover the least amount
form
of information, & the
strong form covers all
Semi-strong information.
All available and • Also note that, each
new public information successive form includes
the previous one.
Reason the Market Efficiency Difficult to Test

1) Different methods for analyzing and valuing stocks

If one investor looks for
undervalued market Therefore, one argument
opportunities while another against the EMH points out
The efficient market hypothesis
evaluates a stock based on its that, since investors value
assumes all investors perceive
growth potential, these two stocks differently, it is
all available information in
investors will already have impossible to determine what a
precisely the same manner.
arrived at a different stock should be worth under an
assessment of the stock's fair efficient market.
market value.

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Reason the Market Efficiency Difficult to Test
– Con’t

2) Emotions and the herd instinct

Stock prices can be affected For example, for the crash of
by human error and Emotions and the herd 2020, panic due to COVID-19
emotional decision making. instinct played the key role in likely caused herd behavior
Herding behavior is when all buy and sell decisions. The in investors, who then sold
market participants act in EMH doesn’t account for out of fear of losing money
the same way to the these. from a possible significant
information available. market decline.

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Reason the Market Efficiency Difficult to Test
– Con’t

3) Availability of information to investors

All investors rarely have the
It is a well-known failing of
same information. Even if the
people that they tend to ignore
same information is available to
information that contradicts
them, they may choose to
their views and overweight
ignore it when making a buy or
information that supports it.
sell decision.

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Reason the Market Efficiency Difficult to Test
– Con’t

4) Human Bias
Confirmation bias If an investor is
can occur when bullish on a stock,
investors only only articles and
accept and research research that
information that support the bullish
supports their view view would be
of the investment. considered.
As a result, the These biases have
investor might miss been shown to exist,
or avoid pertinent but determining the
information that incidence and level
might cause the of a particular bias
stock's price to at a particular time
decline. has its.

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Reason the Market Efficiency Difficult to Test
– Con’t

5) Market are not always right

Speculative economic
bubbles are an obvious
For example, sudden market
anomaly, in that the market These bubbles are typically
crashes, like the one that
often appears to be driven followed by an overreaction
occurred on Black Monday in
by buyers operating on of frantic selling that ends
1987 and financial crisis in
irrational exuberance, who with a sharp price decline.
2008.
take little notice of
underlying value.

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