NAVYA BEHL

215PGE031

EFFICIENT MARKET HYPOTHESIS

According to the EMH, stock always trade at their fair value on stock exchanges, making it
impossible for investors to either purchase undervalued stocks or sell stocks for inflated
prices. As such, it should be impossible to outperform the overall market through expert
stock selection or market timing, and that the only way an investor can possibly obtain the
higher returns is by purchasing riskier investments.
As defined by Eugene Fama: "In an efficient market, competition among the many intelligent
participants leads to a situation where, at any point in time, actual prices of individual
securities already reflect the effects of information based both on events that have already
occurred and on events which, as of now, the market expects to take place in the future. In
other words, in an efficient market at any point in time the actual price of a security will be a
good estimate of its intrinsic value."
The Efficient Market Hypothesis (EMH) is a crucial concept in financial economics, asserting
that stock prices accurately reflect all available information. It postulates that investors
cannot consistently outperform the market through technical analysis or fundamental
analysis. The EMH is divided into three levels of market efficiency: weak form, semi-strong
form, and strong form.
EMPIRICAL TESTS
To evaluate whether a market adheres to the EMH, various empirical tests are conducted.
These tests aim to determine whether past prices, publicly available information, or even
private information can be used to predict future stock prices and generate excess returns.
By examining how markets actually behave, these tests provide valuable insights for
investors, policymakers, and financial economists.

Tests of Weak Form Efficiency

1. Runs Test: This test compares the number of consecutive upticks and downticks in a
stock price to the number that would be expected if the price were following a
random walk. If the observed number of runs is significantly different from the
expected number, this suggests that the price is not following a random walk and
that the market is not weak-form efficient.
2. Autocorrelation Test: This test measures the correlation between a stock price and its
past values. If there is no autocorrelation, then the price is said to be serially
independent, which is a necessary condition for weak-form efficiency.
3. Serial Correlation Coefficient: It Quantifies the strength of linear dependencies
between past and present prices. This coefficient measures the strength of the linear
relationship between a stock price and its past values. A value of 1 indicates a perfect
positive correlation, while a value of -1 indicates a perfect negative correlation. A
value of 0 indicates that there is no correlation between the price and its past values.
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4. Variance Ratio Test: This test compares the variance of short-term price changes to
the variance of long-term price changes. If the variance of short-term price changes
is significantly greater than the variance of long-term price changes, this suggests
that the market is not weak-form efficient.

Example: Random Walk Theory:

Case Study: Burton Malkiel's "A Random Walk Down Wall Street" is a classic example.
He examined whether stock prices move randomly, without following predictable
patterns. Malkiel argued that past stock prices do not predict future prices,
supporting the random walk theory.
Empirical Test: Studies analysing historical stock price data using statistical tests like
autocorrelation or runs tests. These tests check for any serial correlation or patterns
in stock price movements. If prices exhibit randomness, it supports weak form
efficiency.

Tests of Semi-Strong Form efficiency

1. Event Study: This study examines the impact of publicly available news events on
stock prices. If prices immediately adjust to reflect the event's information content, it
supports semi-strong form efficiency. Delayed or excessive price reactions suggest
that prices are not fully incorporating public information.
2. Earnings Surprise Test: This test analyses the impact of unexpected earnings
announcements on stock prices. If prices react quickly and accurately to earnings
surprises, it supports semi-strong form efficiency. Slow or incomplete price
adjustments suggest that prices are not fully incorporating public information.
3. Value Line Ranks Test: This test examines whether stocks with high Value Line
rankings consistently outperform stocks with low rankings. If rankings are not
predictive of future returns, it supports semi-strong form efficiency. Consistent
outperformance based on rankings suggests that prices are not fully incorporating
public information.

Example: Indian Market & Quarterly Earnings Reports

Case study analysing the market's response to quarterly earnings reports of major
companies listed on the Bombay Stock Exchange (BSE) or the National Stock
Exchange (NSE) serves as an illustration of semi-strong form efficiency.
Analysing these reports and stock behaviour using event analysis helps determine if
stock prices swiftly adjust to this public financial data, supporting the idea of semi-
strong form efficiency. This study showcases how effectively the Indian stock market
incorporates publicly available financial information, particularly quarterly earnings
reports, into stock prices.
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215PGE031

Tests of Strong Form Efficiency

1. Insider Trading Studies: These studies examine whether insiders who have access to
non-public information can consistently outperform the market. If insiders can
consistently beat the market, it contradicts strong-form efficiency, suggesting that
private information is not fully reflected in prices.
2. Market Microstructure Studies: These studies analyse the impact of trading costs,
bid-ask spreads, and other market frictions on stock prices. If these factors
significantly affect returns, it suggests that prices are not fully incorporating all
information, contradicting strong-form efficiency.
3. Arbitrage Studies: These studies search for opportunities to exploit discrepancies
between prices in different markets or asset classes. If profitable arbitrage
opportunities exist, it suggests that prices are not fully reflecting all available
information, contradicting strong-form efficiency.

Example: Insider Trading Studies:

Case Study: Seyhun (1998) conducted research on insider trading and market
efficiency. He studied whether insider trades consistently yielded abnormal returns,
indicating that insiders had access to non-public information. Seyhun's findings
suggested that insider trades were not consistently profitable, supporting strong
form efficiency.
Empirical Test: Analysing historical data on insider trades and subsequent stock price
movements to assess whether insider information consistently leads to significant
market outperformance.

Empirical evidence on the EMH is mixed. Some studies provide support for the EMH,
while others find anomalies and contradictions. The debate over the EMH's validity is
ongoing, and it remains an important area of research in financial economics.