EFFICIENT MARKET HYPOTHESIS

Random walk theory

Successive stock prices are independent and they

do not follow any regular pattern.
History of the Random-Walk Theory

 Frenchmathematician, Louis Bachelier in 1900 wrote

a paper suggesting that security price fluctuations
were random.
 In1953, Maurice Kendall in his paper reported that
stock price series is a wandering one.
 Each successive change is independent of the previous
one.
 In1970, Fama stated that efficient markets fully
reflect the available information.
 Random walk is a stock market theory that states that the past
movement or direction of the price of a stock or overall market cannot
be used to predict its future movement. Originally examined by
Maurice Kendall in 1953, the theory states that stock price fluctuations
are independent of each other and have the same probability
distribution, but that over a period of time, prices maintain an upward
trend.
 In short, random walk says that stocks take a random and unpredictable
path. The chance of a stock's future price going up is the same as it
going down.
 A follower of random walk believes it is impossible to outperform
the market without assuming additional risk. In his book, Malkiel
preaches that both technical and fundamental analysis are largely
a waste of time and are still unproven in outperforming the
markets.
Key arguments for random walk theory
 Information is freely and instantaneously to all the market
participants.
 The market will fully impound all available information.
 Price changes only in response to new information
 Since new information cannot be predicted in advance, so
price changes cannot be forecasted.
 Hence price behave like a random walk.
Forms of Efficiencies

They are divided into three categories:

 Weak form
 Semi-strong form
 Strong form

The level of information being considered in the

market is the basis for this segregation.
 Weak Form of EMH
 Current prices reflect all information found in the past prices and
volumes. This means that there is no relationship between past and
future price movements. Buying and selling activities of the
information traders lead the market price to align with the intrinsic
value.
 Because it assumes that current market prices already reflect all
past returns and any other security market information, this
hypothesis implies that past rates of return and other historical
market data should have no relationship with future rates of
return (that is, rates of return should be independent). This threw
cold water on the practice of technical analysis—the study of stock
price charts to divine future price movements.
 Therefore, this hypothesis contends that you should gain little
from using any trading rule that decides whether to buy or sell a
security based on past rates of return or any other past market
data.
Semi-Strong Form
 The security price adjusts rapidly to all publicly available
information.

 Theprices not only reflect the past price data, but also the
available information regarding the earnings of the
corporate, dividend, bonus issue, right issue, mergers,
acquisitions and so on.

 Totest market efficiency specific investment strategies are

examined to see whether they earn excess return by using
CAPM, APT or some other model.
 Efficiency and Anomaly:
 ‘Most of the price reaction is completed immediately after
earnings are announced. There is little delay in the reaction,
so there is little opportunity to earn abnormal returns from
the market systematically erring in its response to the
announcement.’
 Semi-strong form test Stock split: A firm may ‘split’ its shares
by increasing the number of shares of common stock and
reducing the par or stated value per share in the proportion. No
new money is raised and cash flow are unchanged therefore
prices should not react purely to stock split.
 Apparent market inefficiencies have been identified on specific
markets at particular time. Weak effect, Monday effect, Hour
of the day effect, January effect Anomalies (seasonal or cyclical
effect)
Strong Form
 All information is fully reflected on security prices.

 Itrepresents an extreme hypothesis which most observers

do not expect it to be literally true.

 To test the strong form efficient market hypothesis, researchers

analyzed the returns earned by certain groups like corporate
insiders, specialists on stock exchange and mutual fund
managers.
 Efficiency and Anomaly:

 To test the strong form efficient market hypothesis,

researchers analyzed the returns earned by certain groups
like
 corporate insiders,
 specialists on stock exchange and mutual fund managers

 Fama acknowledged that strong market efficiency could not

be an entirely realistic model for the markets, since certain
nonpublic information clearly pre­sented a profit op­por­tu­nity
for those who pos­sessed it.
Market Efficiency
Strongly efficient market
All information is reflected
on prices.

Semi-strong efficient market

All public information is
reflected on security prices

Weakly efficient market

All historical information
is reflected on security
prices.
Levels of Information and the Markets
 IMPLICATIONS FOR INVESTMENTS
 Substantial evidence in favour of randomness suggests that
technical analysis is of dubious value.

 Routine and conventional fundamental analysis is not of

much help in identifying profitable courses of action still
held out hope for fundamental analysts


 The key levers for earning superior rates of returns are:

 Early action on any new development.
 Sensitivity to market imperfections and anomalies.
 Use of original, unconventional, and innovative modes of analysis.
 Access to inside information and its sensible interpretation
 An independent judgment that is not affected by market psychology.
 Which of the following statement defines the efficient market.
 A-Information is fully reflected in stock price
 B-The stock exchange is fully automated
 C-Free entry and exit in market
 D-Market is monitored by regulated authority

 In weakly efficient market stock price reflects

 A-company financial performance
 B-The demand of the script
 C-The past price and traded volumes

 If the market are efficient the security price provides-

 A-Inadequate return for taking risk
 B-Normal return for the level of risk
 C-Abnormal return
 corporate insiders, specialists on stock exchange and mutual
fund managers takes abnormal profit which is inefficiencies
of ----------- form of EMH