EFFICIENT MARKET HYPOTHESES

Efficient Market Hypotheses



Application and Critical Evaluation of Efficient Market Hypotheses for a company during 2 years period

Introduction

The efficient market hypothesis is a finance-related hypothesis which suggests that financial markets are, as a general rule, efficient through information. This mean that it is impossible to achieve consistent returns which are in excess of the average market return due to the information which is available to investors at the time their investment is made. There are actually three different main versions of the efficient market hypothesis--the "weak" hypothesis, "semi-strong" hypothesis and "strong" hypothesis. Each version of the hypothesis has a revised or tweaked variation on the main hypothesis (Kim & Nelson, 1991).

The weak efficient market hypothesis states that the price on traded assets such as stocks and bonds reflects all public information which was available prior to its current price. The semi-strong efficient market hypothesis states that the prices on traded assets reflect all public information and that the prices of traded assets will change instantly when new public information is made available. The strong efficient market hypothesis states that the prices of traded assets will instantly change to reflect all information, including public and private or insider information. Essentially, all forms of this hypothesis state that information—public and private or insider—will reflect on the price of traded assets, like stocks, bonds, etc., to a certain degree.

Discussion

The strongest version of the efficient market hypothesis predicts that the market will follow a 'random walk.' That is, it predicts that, at any given time, any given stock, and the market as a whole, is just as likely to rise as to fall. The long term tendency of the market and all stocks within it will thus be nothing but an accumulation of random decisions. Long-term trends should be impossible to identify. More precisely: as soon as trends become identifiable, they disappear, because investors will buy and sell stocks according to any apparent trend. In doing so, they negate it. If the stock can be reasonably expected to rise for the rest of the year, investment decisions will incorporate this future value—with appropriate discounting—into the present price.

By necessity, the efficient market hypothesis can only ever constitute a rough approximation. For the hypothesis to work correctly, the market has to be filled with a number of intelligent and rational agents who act on their assessments of trends and value. Paradoxically, if these agents were to all assume the efficient market hypothesis, the system would fall apart. The most active participants in the market must believe, to some degree, that they are capable of making profitable decisions on the basis of new information or evaluations.

Because of this paradox, and because of a large amount of data opposing it, the efficient market hypothesis is extremely controversial. It remains a core element of neoclassical economics, and is still widely taught. Many economists probably consider the hypothesis to be a good description of a market functioning ideally. However, real world markets all deviate from perfect efficiency, some ...