Efficient Market Hypothesis, Essay Example

Introduction

This paper is based on the topic of corporate finance and the topic is ‘Efficient Market Hypothesis’. This topic is divided into two parts. One is the identification of the three forms of market efficiency as given by Eugene Fama. The second part is about the efficient market hypothesis and its critical analysis. The second part explain the impacts of efficient market hypothesis on the stock prices and also tells us that how different investors behave in the efficient market.

Part 1: Three forms of Market Efficiency by Fama

The concept of efficiency of market is used to describe the relationship between share prices and information in the market of capital literature. Although the market efficiency test were early reported in the year 1900, but it was until the period of 1953 that the market efficiency idea was given by Kendall Maurice. The by concept product was a discovery of change through the prices behavior and in his paper he had talked about the commodities and stocks. The security prices is discovered to follow a random walk which implied the changes of price that are independent from each other. Fama (1970) gave the general definition of the ‘Market Efficiency’. The market efficiency was classified by Fama as a market that is efficient in a form that is weak and if there are changes in the prices of stock that cannot be judged on the basis of historical return. The semi-robust efficient market is that if the prices of stock instantaneously show any available information publicly. This form of market efficiency is strong and its hypothesis states that the prices show all types of information whether privately or publicly. So, the three forms of market efficiency as suggested by Fama are Weak, Strong, Semi-strong and weak.

The market efficiency form is weak when the hypothesis so that the returns on stock are correlated seriously and there is a constant mean. The weak form of market efficiency shows that if the prices of the current stock reflect fully the information presented in the prices historically, which then implies that there can be a trading plan devised by the investor on the basis of the patterns of prices to give returns that are abnormal. An economically and a weaker more sensible type of the hypothesis indicates that the reflection of information in regards to price are to the point where the benefits are marginal. This means that the information used is for the profits to be make and it does not cross the costs marginally. This theory has led to many form of weak-market efficiency tests that has influenced the interpretation of the different irregularities in the returns on stocks that have been so far documented. On the basis of mixed results against and for the market hypothesis, Fama (1971) made all the alterations into three types. In order to give a more general idea of the weak type of efficiency market testing, the returns are predictable and there are tests on the forecasting of returns that are linked with different variables (Liu & Narayan, 2011). These variables are interest rates and the yield on dividends. Moreover, the problems such as the cross-sectional predictability for the asset-pricing testing models and anomalies like the effect of size, returns seasonality like the January impact, the week effect have been comprises under the predictability of the return theme.

In the half-strong type of efficiency of market it is assumed that the securities prices will immediately change and rationally in relation to the market and new information neither the overreactions of the relays in regards to the new information. This describes that the investors cannot get the returns in excess by establishing the rules of trading based on the information available publicly. The studies have showed a price response to the stock prices which is the main issue for the efficiency of the market. Most of the studies signify a crucial part of the research in the capital markets such this allow to break the equilibrium and the market efficiency issues and give the mostly supported proof on efficiency. Fama (1991) explains the documents showing the irregularities in relation to the dividend decisions and its effect of the stock prices and the corporate control change etc.

Critical Discussion of the Efficient Market Hypothesis theory

There is an intense debate among the financial professionals and the academics regarding the Efficiency market Hypothesis (EMH).This theory states that at any time given, the prices of security reflects completely the information available. The EMH implications on the market is truly profound. Most of the people sell and buy securities (stocks preferably) but in order to do so they need to go for certain predictions. They will assume that the securities they buy are worth the price they are paying and they will get good returns when they sell these securities. But the thing is that market are not always certain. This is where the role of efficient markets come into place. When there is an efficient market the present prices of the stock are fully reflection in the information rather than selling and buying securities in an attempt to effectively change the game of the market to outperform. This concept was evolved with the help of Eugene Fama, where she made an argument that the market which is active comprises of intelligent investors and who are well informed. They know that the stock they buy will appropriately reflect the information available. If there is efficiency of market, the analysis or no information can result in the outperformance of the stock market (Bollen, Mao & Zeng, 2011).

The term ‘Efficient’ means that the market where there are huge numbers of profit maximizers, rational and actively competing investors. Each of them tries to predict the future of the values of the market and the individual securities they hold. Here the present information is almost available freely to all the participants of the market. In the efficiency of the market, the competition among these intelligent investors leads to a conditional at any point if time where the actual price of the securities of these individuals reflect the information effects based on events that have already incurred. For this, the expectation of the market plays an effective role in the future. In other words, the market that is efficient can be at any point of time will show the actual security price will be a better estimate of the value that is intrinsic (Fama, 1970). The walk theory randomly asserts the movement of the price will not follow the trends or patterns and the movement of the price cannot be predicted in the price movements in the future. Most of this theory is subjected to be traced to Louis Bachelier who is a French Mathematician and he has written a dissertation on ‘Speculation theory’. In this theory he has included some insights and commentary which are remarkable. He concluded that the ‘Expectation of the mathematics is spectacularly zero’. He explained that this condition is a fair game. Unfortunately, the insights which he had given went unnoticed largely for over 50 years until his theory was rediscovered.  The investors practice incur the cost of trading and not all of them behave in a homogenous manner. In relation to the information that had led to the researching of huge amount produces an evidence against and for the proposition that the markets of finance are efficient. In spite of these controversies, the market hypothesis theory has contributed to the understanding as to when and how the industry and the economic information is encoded in the securities prices. This hypothesis also gave a very beneficial insight on the informational role in the stock prices determination (Van Heerden et al., 2013).

The strong form of the market efficiency predicts that the prices will be reflected in all the new information i.e. either private or public. This private information tests help to ascertain whether such type of information fully reflects the prices of the market. Fama (1991) reviewed the private information tests and conduced that the profitability is now established under insider trading. This refers to the private information use which affects the earning of profits that are abnormal. The proof shows that there are some analysts of investment that have insider information. This information if evidently balanced when they don’t use this information. The term efficient stock market has stimulated both controversy and insight since its intro to the financial literature and economies. The efficiency market hypothesis shows the consequences of the financial market competition in showing the values of financial assets in equilibrium (Ghazani & Araghi, 2014). Perhaps the most crucial implication of this EMH is the price of the market and its security which reflects the rational, true or value of the security. Thus, in the market efficiency, the investors are assured that their security prices are priced fairly. This is a strong precondition of the hypothesis which shows the trading costs, information the cost of prices to reflect this information is zero (Zhang, 2013).

In several researches, we can see that there is an empirical evidence that is uncovered and it suggest that the returns on stock comprises of components that are predictable. It was found significant statistically that the stock prices predictability using the forecasts is based on certain variables that are predetermined. French and Fama (1988) explains that the period of holding returns is long significantly impacts the correlated serials. He implied that there is 2 30-40% chance that the variations will have a longer-horizon of returns as predictable from the historical profits (Lindvall & Rangert, 2012). This theory was rejected by Muller (2013), where he said that the hypothesis of random walk shows that it is inconsistent with the weekly reruns stochastic behaviors specially if there is a smaller stock capitalization. The empirical proof of the return that are abnormal are shown in the variable forms such as market/topic value ratio and the P/E ratio. It has defied the economic explanation rationally and appears to have caused many researchers to robustly qualify for their views of the efficiency of market (Singh, 2013).

Conclusion

To sum up, it can be said that the argument about the market efficiency has resulted in thousands and hundreds of empirical studies which aims to identify the specific markets that are ‘efficient’ in fact. It has been noticed by many investors and it is a surprises that a tremendous amount of this gives support efficiently for the market efficiency hypothesis (Yang et al., 2012). It has been analyzed through various researches that there are numerous abnormalities in other stock markets which seems to contradict the hypothesis of efficient market. The quest for these anomalies search is effectively for the patterns and the systems that can be used to outperform the passive hold and buy strategies. In short, we can say that the debate of efficient market plays an effective role in the decision between passive and active investing.

References

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Kamal, M. (2014). Studying the Validity of the Efficient Market Hypothesis (EMH) in the Egyptian Exchange (EGX) after the 25th of January Revolution.

Lindvall, J., & Rangert, F. (2012). Is the Swedish stock market efficient?: Testing the weak form of efficient market hypothesis.

Liu, R., & Narayan, P. K. (2011). The efficient market hypothesis re-visited: new evidence from 100 US firms (No. 2011_08). Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance.

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Singh, N. P. (2013). Testing Efficient Market Hypothesis for Indian Stock Market. LBS Journal of Management & Research, 11(1), 87-96.

Van Heerden, D., Rodrigues, J., Hockly, D., Lambert, B., Taljard, T., & Phiri, A. (2013). Efficient Market Hypothesis in South Africa: Evidence from a threshold autoregressive (TAR) model.

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