EFFICIENT MARKET HYPOTHESIS

Efficient Market Hypothesis

Efficient Market Hypothesis

Introduction

Efficient market hypothesis is a theory originally developed in the 1960s by E. F. Fama, M. C. Jensen, & R. Roll. In a less well-expressed version of the stock market efficient hypothesis assumes that the successive changes in stock prices are largely linked to each other, and that stock prices change randomly. It is believed that the chance of changes in exchange rates the shares confirmed by the analysis of successive changes in rates, showing low rates of serial correlation. This is shown as a graph of random numbers, showing a model of exchange rate dynamics, similar to the actual models of exchange rate dynamics. For this reason, proponents of the hypothesis of arbitrary changes to dismiss the usefulness of technical analysis, an approach with rum-forecast stock prices based on exchange rate models developed on the basis of preliminary data on rates (Aga, 2008, p. 131-144).

There is widespread disagreement and controversy on this theory because some economists and investors believe that one can beat the market by mathematical trading and by building mathematical models. Some investors believe that by using charting (a form of technical analysis) one can predict the stock price. The efficient market theory, however, has an exception; that is, one can beat the market if one has insider information on the company stock (Aga, 2008, p. 131-144).

However, insider trading is illegal and is subject to heavy fines and a prison sentence. In addition to technical analysis and mathematical trading, there is a group of investors who believe that they can beat the market by applying value-based investment strategy. They reason that the value or price of an asset is the present value of its future stream of earnings or cash flow. Investors can search for stocks that are underpriced based on the present value of their future cash flows (Aga, 2008, p. 131-144).

Accordingly, these investors can beat the market, and the efficient market hypothesis does not hold. An efficient market exists when security prices reflect all available public information about the economy, the financial markets, and the targeted company. All new information is instantaneously captured, and therefore, this causes the prices of stocks to move randomly and makes it impossible to predict the randomness. This movement in prices is sometimes called a random walk because changes in the prices will not follow any defined pattern. Technical analysts using charts claim that they can beat the market by “predicting the random walk” by charting the patterns (Ball, 2009, p. 8-16).

The efficient market theory, however, has an exception; that is, an investor can beat the market if he has insider information regarding the company stock. For example, if an individual knows before the market opens the next day that the company will announce a loss in earnings and that person buys the stock the day before, then that an investor has beaten the market and the efficient market hypothesis does not hold. However, insider trading is illegal and is subject to heavy fines and a prison sentence (Ball, 2009, p. 8-16).

The efficient market hypothesis describes three forms of market efficiency:

Weak-form efficiency

Semi-strong efficiency

Strong-form efficiency

The weak form states that the price of an asset incorporates all past or historical financial information about that ...