PART 2 – EFFICIENCY MARKET HYPOTHESIS

Introduction

In order to better understand the origin and the idea behind the Efficient Market Hypothesis (EMH), an overview of the EMH, The Random Walk Model, different degrees of information efficiency and the implications of efficient markets for investors are studied in the paper.

Efficient Market Hypothesis

The efficiency concept is one of the most essential concepts for investment management and analysis. Market efficiency basically revolves around three related assumptions on proper- allocation efficiency, informational efficiency and operational efficiency.

Efficiency in allocation is a vital characteristic of a strong market wherein the allocation of capital is done in a proper way so that it benefits all the participants and helps in promotion of economic growth and status.

Efficiency in operation is another crucial parameter which is used commonly by economists to determine and analyzes how resources are utilized in the market to benefit operational activities in the market and industry.

Efficiency in information helps to determine the actual market value of shares based on its intrinsic value. The Information efficiency signifies that reflection on all available information pertaining to the security’s price must be used to determine the security’s observed market price. (Hossain,Rahman, 2006)

The introduction to the idea of market efficiency was given by Bachelier (1900) and later it was termed as efficient market by Fama (1965)

Fama (1970) further went on to state the vital conditions/ assumptions for maintaining efficiency:

1. Provision of no transactional costs during the trading of securities;
2. All information is freely available to all the participants in the market, and
3. Agreement of all of them on the implications of the information relating to the current price and future distribution of prices of each security

He identified three forms of informational efficiency, which are the weak form(underdeveloped), the semi-strong form(developing) and the strong form efficiency(developed).

Forms of Market Efficiency

Weak-Form Efficiency

Weak form efficiency market implies that it is an efficient market which reflects all its market information accurately and does not provide profit for the investor based on past records or rates. This past records stands invalid for the market. Fama (1970) stipulates in his theory that no investor can avail greater returns when the market is weak-form efficient. Example African economy has a weak efficiency market wherein the means to attain gains on investment is narrow based on past investment experience. Example trading test, auto correlation test and run test.

Semi-Strong Form Efficiency

Semi Strong Form Efficiency market indicates that market is efficient and it reflects all public information. It says that the stocks are absorbant of all new information and incorporates it by adjusting to it. It is partly like the weak form efficiency market wherein the stocks rate are based upon new information that is released after the stocks are bought. So making it difficult for the market to be predictable. Fama (1970) explains the semi-strong form efficient market as the one where share price not only reflect on all information regarding its past and historic prices, but also includes additional public information which is later on integrated with the shared price and adjusted to reveal the true share value. This also implies that an investor will not be able to use the public information for the generation of gains in the evolving stock market. Event tests and time series/ regression tests are some examples.

Strong Form Efficiency

The Strong form efficient market relies on both public as well as private information wherein the stock prices are based and reflected upon. So an average investor cannot make much profit more than others also when he is given the new information. It incorporates both the weak form and semi strong form of market efficiency. Private information concerns the information that is not yet published or known only to the security analysts/ fund managers. The new public and private information is then incorporated into the share price to represent its true share value. This makes it even more difficult for the investor to assess share values. Examples are insiders, exchange specialists, institutional money managers and analysts who have access to new information.

Fundamental analysis and technical analysis

This analysis makes use of analysing and evaluating the financial statements, health of the business, efficiency of the management and their competitive advantages, while also examining the competition in the market. When applied on forex and futures market it uses production, interest rates, earnings, GDP, employment, manufacturing, housing and management analysis.

While technical analysis predicts the future of market based on past prices, volume and market information. This is useful for behaviour economics and quantitative analysis. Both these methods of analysis contradict the premise and study made on efficiency market theory which states that study of market with accuracy cannot be determined by any method.

Implications of EMH

Market efficiency has some prominent implications concerned with both authorities and investors, which are mentioned below:

When a market is efficient they must

1. Not worry about analysis on their investments, but concentrate rather on developing a diversified portfolio to get rewarded for their investments.

2. Adopt to the policy of buy and hold after establishing their portfolios as making frequent changing by shifting from one securities group to another would raise for them unwarranted transaction costs.

Other implications are based on the fact that changes in price are random and cannot be predicted, investors are smart enough to not get fooled by the financial reports circulated and lastly the timing of security issues are not crucial.

Investors must pay more attention to construct and hold diversified and efficient portfolios rather than taking to fundamental and technical analysis. This approach will definitely benefit them in the long run.

Empirical Evidences for anomalies

The empirical evidence lists some of the significant ‘anomalies’ which contradict the efficient market theory as listed below:

The January Effect

It is often noticed that the stock returns raise high abnormally in the first week of January which is defined as the January effect wherein most of the investors opt to sell some of the stocks befor the year end and later claim for a capital loss to evade tax and then go on to make their reinvestments later on. (Rozeff and Kinney, 1976)

Size Effect

The Size Effect is the small firm’s tendency, which holds a small capital market, to outweigh and surpass the market of larger companies and rise as an underdog over the long term. (Banz, 1981) and (Reinganum, 1981)

Weekend Effect

This is a notable phenomenon wherein the stock returns are observed to be comparatively lower on Mondays as against those on the preceding Fridays. ( French, 1890)..

Value Effect

The value effect related to the nature of stocks that hold low cost, earnings ratio to outdo other alternative portfolios of stocks which have higher cost, earnings ratio.

Empirical Evidences from Developing Countries

Despite huge empirical studies conducted in order to test and validate the Efficient Market Hypothesis in developed countries which witness a flourishing financial market, the pertinent studies on weak efficiency markets are limited in countries like Africa. Most developing and underdeveloped countries suffer a setback due to the problem of thin trading (Mlambo and Biekpe, 2005). Fisher (1966) who first identified this bias due to thin trading on his observation on correlation of return index, stated that the security’s price that are recorded are not similar to their respective underlying values based on theory as when a share trade fails, the recorded price remains the closing price as per the last share trade. It is also stressed that reasons like transactional costs, delay in operations and illiquidity of the market are crucial in determining a concrete statistical evaluation of the study.

Bibliography

Cohen, W. W., 1996. Learning trees and rules with set valued features. s.l.:s.n.vol1.

Fama, E., 1970. Efficient Capital markets: A review of theory and empirical work. 1ed. s.l,American Economic Review.

Fisher, R. A., 1966. The design of experiments. 8ed. New York: Hafner publishing.

Mikhail, M. W. R., 2004. Do security analysts exhibit persistent Differences in Stock picking ability. s.l.Journal of financial economics.

Reiter, S. W. P. F., n.d. Scientific conversations in financial economics. Burlington: Ashgate publishing company.