Efficient Market Hypothesis

RANDOM WALK HYPOTHESIS

• The theory that stock price changes have the same distribution
and are independent of each other, so the past movement or
trend of a stock price or market cannot be used to predict its
future movement.
• In short, random walk says that stocks take a random and
unpredictable path.
• Under the random walk theory, there is an equal chance that a
stock's price will either rise or fall from current levels.
RANDOM WALK HYPOTHESIS
• While EMT suggests that stock is always efficiently priced this
theory suggests that price behaviour is never based on
anything predictable, but is completely random.
• The random walk theory is the belief that price behaviour
cannot be predicted because it does not act on any predictive
fundamental or technical indicators.
RANDOM WALK HYPOTHESIS
• Random walk hypothesis, 1st espoused by French
mathematician Louis Bachelier in 1900, which states that stock
prices are random, like the steps taken by a drunk, and
therefore are unpredictable.
• A few studies appeared in the 1930’s, but the random walk
hypothesis was studied and debated intensively in the 1960’s
RANDOM WALK HYPOTHESIS
• Chartists and technical theorists believe historical patterns can
be used to project future prices. While the random walk
hypothesis claims that such movements cannot be accurately
predicted.
RANDOM WALK HYPOTHESIS
• Information is freely and instantaneously available
• Keen competition among market participants
• Prices change only in response to new information
• Since new information cannot be predicted in advance, price changes
too cannot be forecast.
EFFICIENT MARKET HYPOTHESIS
Market efficiency is defined in relation to information that is reflected in
security prices.

• Weak-form efficiency Prices reflect all information found in the record

of past prices and volumes.
• Semi-strong form efficiency Prices reflect not only all information found
in the record of past prices and volumes but also all other publicly
available information.
• Strong-form efficiency Prices reflect all available information, public as
well as private.
 Relation of 3 Forms of EMH

Strong

Weak
Past Market All Public All Public &
Info Info Private
Info

Semi-
Strong
 Three Forms Of Market Efficiency
Form Definition
Weak Financial asset (stock) prices
incorporate all historical
Form information into current prices;
future stock prices cannot be
predicted based on an analysis
of past stock prices.
Semi- Stock prices incorporate all
strong publicly available information
Form (historical and current); there will
not be a delayed response to
information disclosures.
Strong Stock prices incorporate all
Form information--private as well as
public; prices will react as soon
as new information is generated,
rather than as soon as it is
publicly disclosed.
Example
Nothing of value is to be
gained by analyzing past stock
price changes, since this
doesn’t help you predict future
price changes. Renders
“technical analysis” useless.
The relevant information in an
SEC filing will be
incorporated into a stock
price as soon as the filing is
made public.
Stock prices will react to a
dividend increase as soon as
the firm’s board of directors
votes--and before the board
announces its decision
publicly.
Misconceptions about the Efficient Market
Hypothesis
• The efficient market hypothesis implies that the market has perfect
forecasting abilities.
• As prices tend to fluctuate, they would not reflect fair value.
• Inability of institutional portfolio managers to achieve superior
investment performance implies that they lack competence.
• The random movement of stock prices suggests that the stock market
is irrational.
EMPIRICAL EVIDENCE
Empirical Evidence on Weak-form Efficient Market Hypothesis
Returns over Short Horizons
• Serial Correlation Tests
• Runs Tests
++-+++
• Filter Rules Test
Returns over Long Horizons
• "fads hypothesis"
Empirical Evidence on Semi-strong Form
Efficient Market
• Event study
• Portfolio Study