EFFICIENT MARKET HYPOTHESIS

Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH)

Introduction

Bachelier (1900) laid the foundation of EMH, later the efficient market hypothesis was developed by Eugene Fama in 1960s. It is a market which adjusts quickly to new information (Fama et al, 1969) Efficient Market Hypothesis states that it is not possible for investors to buy undervalued stocks or sell stocks for overstated prices, and it is also not possible to beat the market because prices always reflect all relevant information. Although investors can gain higher average returns by buying riskier investments.

According to the efficient market hypothesis, whenever investor is buying and selling securities, he is engaging in a chance of luck, not skills. You cannot buy stocks at a bargain price as prices always reflect all information when markets are efficient and current. A modern way to define EMH is that asset prices reflecting all available information (Fama, 1991). Chances of winning or losing in price variation increases, the longer your hold a security (Regnault, 1863).

Tests of the Efficient Market Hypothesis

There are three levels of the hypotheses that we are going to distinguish between them one by one. The three levels of EMH are weak form, semi-strong form, and strong form (Dobbins and Witt, 1979. p. 65).

Weak Form Test

In weak form test, one cannot predict future prices on the basis of past prices of shares. Gain on average return in excess amount cannot be earned for long term by analyzing past prices or information using investment strategies. Share prices have no pattern and show signs of no serial dependency. It means future prices are not on price series, but entirely determine by information. Therefore, prices must pursue a random walk.

Semi strong form test

In this form of testing, it is whether the market is efficient and share prices are to publicly available information about businesses in an unbiased manner. Testing helps in choosing information event and answers the question whether the market has responded quickly and sensibly. It also implies that excess amount will not be produced by using technical analysis and fundamental analysis techniques because any fact that might change technically or fundamentally are in the security price. All in all, this test suggest that the investor can have the benefit to earn abnormal returns on investment based on the information which not publicly available.

Strong form test

In this form of test, it tells us that all information, whether public or private, in a market is for in the stock market. Investor cannot gain advantage even on the insider information. Investor cannot gain profit surplus to normal returns, in spite of the fact that the investor has an access to information or research. Any technical analysis and fundamental analysis are useless for investor.

Below are the reasons why market efficiency hypothesis is a critical issue and concept.

It has an effect on the price when the firm will obtain from the issuance of new stocks and bonds.

It has an effect on rate on return ...