EFFICIENT MARKET HYPOTHESIS

Efficient Market Hypothesis



Efficient Market Hypothesis

Efficient Market Hypothesis

The efficient market hypothesis (EMH) is a belief that financial asset markets are fully efficient and thus correctly reflect all information. It evolved in the wake of work by Kendall (1953). He found price seemed to follow random walks, so that future price changes could not be predicted on the basis of past prices. The importance of news for asset prices led to the idea of the EMH.

Definition

The efficient markets hypothesis (EMH) holds that a stock market is efficient if the market price of a company's shares (or other financial securities, such as bonds), rapidly and correctly reflects all relevant information as it because available. (Lumby & Jones, 1999) In a truly efficient stock market, if all information turned out to be entirely reliable and complete, share prices could be relied upon to correctly reflect the true economic worth of the shares.

For a market to be efficient, three assumptions are needed, as shown below.

All information relevant to financial asset prices must be costlessly, widely and quickly available. In information is costly to secure, or is known only to some investors, or spreads slowly, then asset prices might not reflect all information.

There must be no transactions costs in purchasing or selling financial assets. Otherwise, if news arrives that leads people to believe that some assets are more attractive, then their price may not rise to reflect this because the transactions costs involved in buying them could outweight the gains that might be made.

Investors must act rationally on the information they have, for otherwise asset prices will not correctly reflect available information. (King,1999)

Levels of market efficiency

Before discussing why the concept of market efficiency is important for financial managers, some questions must be answered. If stock markets are so efficient:

Why have markets, institutions and individuals not always responded to significant changes in information ranging from patterns of dividend distribution to major political events?

How can investors earn excess returns from changing fundamentals, technical analysis or Quants analysis of either market trends (based on the CAPM), or individual factors such as inflation, interest rates, industrial performance and risk attitudes?

Conversely, if not a direct consequence, why do even professionally managed institutional portfolios periodically under-perform relative to the market as a whole? (Hill, 1998)

To explain why, the EMH has been propounded in three levels of market efficiency:

Weak form efficiency

Semi-strong form efficiency

Strong form efficiency

Weak form efficiency is the lowest level of efficiency. It implies no more than that share prices fully reflect any information that may be obtained from studying and analysing past movements in the share price. It states that only knowledge of past share prices is fully absorbed into today's price. The next price change is random in relation to currently available information concerning past prices, thereby debarring technical analysts from making excess returns. Thus if the market is weak form efficient, it will not be possible to identify mispriced securities by analysing their past prices.

Semi-strong form efficiency is the next ...