EFFICIENT MARKET HYPOTHESES (EMH)

or
RANDOM WALK THEORY
 RANDOM WALK

 Maurice Kendall found that stock prices followed a random

walk, suggesting that successive price changes are independent
of one another.
 A number of researchers have employed ingenious methods to
test the randomness of stock price behaviour.
 Academic researchers concluded that the randomness of stock
prices was the result of an efficient market.

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 EFFICIENT MARKET
 An efficient market is one in which security prices adjust rapidly
to the arrival of new information and, therefore, the current prices
of securities reflect all information about the security.
 Market efficiency research examines the relationship between
stock prices and available information.
– The important research question: Is it possible for investors to
“beat the market?”
– Prediction of the EMH theory: If a market is efficient, it is not
possible to “beat the market” (except by luck).

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 What Does “Beat the Market” Mean?

The excess return on an investment is the return

in excess of that earned by other investments that
have the same risk.

“Beating the market” means consistently earning

a positive excess return.

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 EFFICIENT MARKET HYPOTHESES (EMH)

Market efficiency is defined in relation to information that is reflected in

security prices. Nobel Prize Laureate E. F. Fama distinguishes three levels of
market efficiency.
(1) weak-form EMH, (Past price information)

(2) semi-strong-form EMH, (Publically available information)

(3) strong-form EMH. (All information- public and private or inside)

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 What Information is Used?
 A Weak-form Efficient Market is one in which past prices and volume
figures are of no use in beating the market.
– If so, then technical analysis is of little use.

 A Semistrong-form Efficient Market is one in which publicly available

information is of no use in beating the market.
– If so, then fundamental analysis is of little use.

 A Strong-form Efficient Market is one in which information of any kind,

public or private, is of no use in beating the market.
– If so, then “inside information” is of little use.

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Weak-form EMH, (Past price information):
 The weak form of the EMH says that the current price of stocks
already fully reflect all the past information. The new price
movements are completely random. They are produced by new
pieces of information and are not related to past price movements.

 This implies that technical analysis, which relies on charts of price

movements in the past, is not a meaningful analysis for making
abnormal trading profit.

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Semi-Strong-form EMH, (Publically available information)
 Publically available information:- company announcements, press releases,
announcements of dividend, stock splits etc.

 The implication of semi strong form EMH is that fundamental analyst can
not make higher gains by undertaking fundamental analysis because stock
prices adjusted to new pieces of information as soon as they are received.
There is no time gap in which a fundamental analyst can trade for superior
gains.

 Thus the semi strong hypothesis disclaims fundamental analysis.

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Strong-form EMH (All information- public and private or inside)
• This implies that no information, whether public or inside, can be used to
earn extra returns consistently.

• In an efficient market, it is impossible to make above-average

return regardless of the information available, unless abnormal
risk is taken. Moreover, no investor or group of investors can
consistently outperform than the other investors in such a
market.

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 SUMMING UP
• Stock prices appear to follow a random walk. The
randomness of stock prices is the result of an efficient market
• It is useful to distinguish three levels of market efficiency :
weak form efficiency, semi-strong form efficiency, and strong
form efficiency.
• The weak form efficient market hypothesis says that the
current price of a stock reflects all information found in the
record of past prices and volumes.
• The semi-strong form efficient market hypothesis holds that
stock prices adjust rapidly to all available public information.
• The strong form efficient market hypothesis holds that all
available information, public and private is reflected in stock
prices.
• Empirical evidence seems to provide strong support for weak
form efficiency, mixed support for semi-strong form
efficiency, and weak support for strong-form efficiency.
• The efficient market hypothesis is an imperfect and limited
description of the stock market. However, at least for the
present, there does not seem to be a better alternative.
• The key implications of the efficient market hypothesis are
that technical analysis is of doubtful value and routine
fundamental analysis is not of much help.