FUNDAMENTAL AND

TECHNICAL ANALYSIS

MODULE- 3
Efficient Market Hypothesis
 Introduction
• It is important for investors to understand the market
environment in which securities are priced. Economists have
diligently classified markets based on the number of sellers,
the nature of competition among them and various
permutations of demand and supply conditions.
• The investment analysis framework helps an investor to study
the behaviour of stock prices, which involve fundamental
analysis, technical analysis and efficient market hypothesis.
 RANDOM WALK THEORY

• Many persons believe that securities market prices can never be predicted,
because of inability to identify definite causes for many of the fluctuations in
prices. They believe that such fluctuations are mere statistical ups and
downs. This belief or hypothesis is known as Random Walk Hypothesis.
• Assumptions of random walk theory:-

a) Behaviour of securities prices are unpredictable;

b) There is no ascertainable relationship between the present prices and future

prices and;

c) Fluctuations in securities prices are statistically independent of the past

history. In other words, successive peaks and troughs are unconnected.
 Continued..

• Adoption of this theory prohibits the use of any forecasting

exercise for predicting the future trend in securities prices.
Believers in this theory do not use ‘past history’ of prices
for determining timings for investment. The theory gets its
name from the comparison that is established between
behaviour pattern of prices, and the way in which a
drunken-man may walk in a blind lane. That is why this
theory has been termed as random walk theory.
 Efficient market hypothesis (EMH)

• EMH assumes that all publicly available information is

reflected in the securities prices and it is difficult for an
investor to out perform the market. On the other hand , a
market is said to be inefficient when there is a time lag
between the availability of information and its absorption
in the security prices. The notion that security prices at a
given instant in time reflect all available information is
termed as the efficient market hypothesis.
 Definition

• According to Eugene F. Fama, an efficient market is defined as, “ a

market where there are large number of rational, profit maximisers
actively competing, with each other trying to predict future market
values of individual securities, and where important current information
is almost freely available to all participants. In an efficient market,
competition among the many intelligent 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 of time, the
actual price of a security will be a good estimate of its intrinsic value.”
 Forms of Market Efficiency

• Weak form of efficiency

• Semi strong form of efficiency

• Strong form of efficiency

 a) Weak form of efficiency
• In this the security prices reflect all historical
information about the movements in price. Hence, it is
not possible for an investor to predict future security
prices by analysing the historical prices and achieve a
return better than the index returns. In other words,
excess returns cannot be earned by using investment
strategies based on historical share prices.
Empirical tests of weak form of efficiency

1. Serial correlation is the relationship between a given variable and a

lagged version of itself over various time intervals. Serial correlations
are often found in repeating patterns, when the level of a variable affects
its future level.
• Serial correlation occurs in time-series studies when the errors
associated with a given time period carry over into future time periods.
• Serial correlation is also known as autocorrelation or lagged correlation.
• Highly correlated coefficients indicate dependence on historical data, it
suggests that historical data can be used to predict the future price
behavior of securities.
 2. Run test
• Under this, the direction of movement of stock prices
are examined but not the quantum of movement in
them. An increase in security prices is denoted by +
sign, a – sign represents a decrease and 0 indicates no
change. A consecutive sequence of these signs is
considered as run. A change in the sequence of these
signs indicate a new run.
 3. Filter test
• A filter rule is a trading strategy in which technical analysts set rules for when to buy and sell
investments, based on percentage changes in price from previous lows and highs. The filter
rule is based generally on price momentum, or the belief that rising prices tend to continue to
rise and falling prices tend to continue to fall. It is often considered a subjective screener, due
to it being set by an analyst's own interpretation of a stock's historical price history.
• For an example, under a 1% buy/sell filter rule, an investor would buy a stock when its price
rose to 1% above a previous low and sell it when its price fell to 1% below a previous high.
If this investor only wanted to focus on a bullish trend they could set a filter rule that would
only buy with a 1% increase in the price.
• Research studies of filter rules from 0.5% to 20% have found that lower percentage filters
are more successful than higher percentages. This is especially true in situations where high
trading costs are also associated with a trade.
b) Semi strong form of efficiency
• The semi-strong form efficiency theory follows the belief that
because all information that is public is used in the calculation
of a stock's current price, investors cannot utilize either
technical or fundamental analysis to gain higher returns in the
market. Those who subscribe to this version of the theory
believe that only information that is not readily available to
the public can help investors boost their returns to a
performance level above that of the general market.
 Empirical test of semi strong efficiency

1) Event study:- the steps involved in conducting event study are:

a) Calculate the expected return and the actual return before and after
the event using the market model or the CAPM.
b) Calculate the abnormal return, where abnormal return is the
difference between the expected return and the actual return
c) Calculate cumulative abnormal return

If the value of cumulative abnormal return (CAR) is zero before event,

rise to a positive number just after a event and then stay, then the market
is said to be semi- strong
 2. Portfolio study
• In this test, a portfolio of stock which has the observable characteristic of a
firm like P/E Ratio, price-book value ratio, dividend yield or other
characteristic is created and tracked for a period of time to see whether it is
possible to earn superior risk adjusted returns. It involves:

a)Defining the characteristics on which firms are categorized.

b) Classifying firms into portfolios on the basis of the magnitude of the
characteristics

c) Find out the returns for each portfolio.

d) Calculate excess returns for each portfolio

e) Assess whether the excess returns are different across the portfolios
 c) Strong form of efficiency

• Says that all information, both public and private, is

priced into stocks and that no investor can gain
advantage over the market as a whole. Strong Form
EMH does not say some investors or money managers
are incapable of capturing abnormally high returns
because that there are always outliers included in the
averages.
 Continued…

• Basically, there are two types of tests that can be conducted.

Firstly, test to find those who have access to inside
information and secondly, test to find the performance of fund
managers.
• Insider trading refers to those investment activities of people
who have access to inside information about the companies.
 Continued…

• It can be summarized that insider trading can be used

to earn above average returns while the mutual funds
and financial analysts have not been able to earn
excess returns by using private information.
 Difference between
fundamental , technical
analysis and efficient
market hypothesis
 Difference between FA, TA & EMH

• Fundamental analysis studies the key economic and financial variables to

estimate the intrinsic value of a share. It helps in identifying the nature of
security i.e. whether they are overvalued or undervalued. The analysis is
carried out with in an EIC framework.
• Technical analysis is concerned with a critical evaluation of the price
volume data of the security and the index. It asserts that the history repeats
itself. It seeks to predict the future price movements by analysis of historical
patterns.
• EMH states that no investor can out perform the market. The hypothesis is
expressed in three form viz. weak, semi strong and strong form. It repudiates
both fundamental and technical analysis.