Efficient Market Hypothesis

Presented By Debankur Majumdar

ITM Mumbai

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Efficient Markets
A testable hypothesis to answer the question: How are securities market prices determined?

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The efficient markets hypothesis:
• Securities prices always fully reflect all available, relevant information about the security. • Note the key words of the definition: “always,” “fully,” and “information.”
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What would cause a stock price to change?
• A reasonable answer is that the price would change if investors obtain new information about the stock that causes them to revise their forecast about the stock’s future return. • New information that causes investors to be more optimistic would cause them to revalue the stock price higher. Negative information would result in lower price ITM Mumbai 4 revaluations.

Since new information arrives in the market in an unpredictable (random) fashion, prices will change randomly as well.
• Conclusion: New information is the cause of securities price changes. Since one cannot predict whether the next piece of new information will be favorable or unfavorable for a stock, the future changes in stock prices are ITM Mumbai similarly unpredictable.

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Much empirical research has been done to examine how much (or how fully) information is incorporated in market prices.
• Questions about the extent of the information incorporated has led to several terms to describe the degree of efficiency exhibited in a particular market. • The three terms are “weak form efficient,” “semi-strong form efficient,” and “strong form efficient.” ITM Mumbai

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The weak form efficient markets hypothesis - a definition, and some evidence:
• The weak form hypothesis maintains that past stock price changes cannot be used to earn above average profits. (Because this information is available to all, and thus, already incorporated in market price.)
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Weak form evidence:
• Studies show that systems that try to predict the future course of stock prices based upon some rule derived from the history (past days, weeks, or months) of past stock price changes do not make profit greater than a simple buy and hold strategy. • Statistical analysis of successive stock price changes reveals that the correlation between price changes is approximately zero.
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If a market is weak form efficient, then technical analysis should not be effective in picking stocks for above average profits.
• Technical analysis is the term describing the many systems for investing based on indicators such as charts of past price data, volume of trading, short selling statistics, odd lot trading, etc.
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Despite the evidence for market efficiency, there are many professional investors who claim that technical analysis can be effective. Such claims are largely unproven, but it shows that not everyone accepts the efficient market hypothesis.
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The semi-strong form efficient markets hypothesis - a definition and some evidence:
• The semi-strong form efficient markets hypothesis maintains that all publicly available information is incorporated in stock prices.
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Semi-strong form evidence:
• Studies show that public announcements of earnings, dividends, stock splits, etc. cause stock prices to immediately change to reflect the new information. • Studies show that mutual funds (whose professional managers would be expected to have access to the very best information available) do not consistently outperform the average market indexes. ITM Mumbai 12

If a market is semi-strong efficient, then picking stocks based on publicly available information, should not yield profits greater than what could be obtained using a simple buy and hold strategy.
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Evidence of efficient markets has given great impetus to the formation of “Index Funds,” for investors wanting to minimize research costs and trading costs while investing in a mutual fund that closely tracks a given market index.
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The strong form of the efficient markets hypothesis - a definition and some evidence:
• The strong form of the hypothesis maintains that all information obtainable from any source whatever, is incorporated in market prices.
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Strong form evidence:
• Studies show that “inside information” available to corporate insiders or market specialists could be used to earn above average trading profits • Yet, remember that using inside information is illegal!. Thus, strong form inefficient markets may not be legally exploited to earn greater than average profits, either. ITM Mumbai

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In conclusion:
• There is evidence that markets are weak form and semi-strong form efficient, but probably not strong form efficient. • Yet it must be noted that the tests of efficiency have largely focused on well developed markets in the United States. Foreign markets have been studied less extensively, and may exhibit less efficiency. This is especially true of markets in less developed countries (sometimes called ITM Mumbai 17 “emerging” markets).

Finally, it should be noted that there is some evidence that contradicts the hypothesis.
• Some market studies give evidence that a strategy as simple as buying low P/E ratio stocks can result in above average profit. • Other studies give evidence that the Value Line Investment Survey can be used to earn superior profits. (This is a stock rating service available in many public libraries.)
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The efficient market hypothesis has not been “proven,” however, it is a highly regarded tenant in modern finance.
• If markets are efficient, investors can expect that prices are “fair,” and that the rate of return earned from a diversified portfolio of securities over time will be approximately average for that class of securities.
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