MARKET EFFICIENCY

Market Efficiency



Market Efficiency

Introduction

The assumption that a market is efficient and it is not possible to generate excess risk adjusted return by incorporating publicly available information in buying and selling decisions is known as efficient market hypothesis (EMH). EMH asserts that all the market participants are rational and any new information is immediately incorporated in stock prices. Hence a market will be inefficient if a sample of asset prices is found for which profits are higher than average. Efficient market hypothesis reflects the finance theory's explanation of the manner in which financial markets operate. The EMH is basically derived from Walarsian Economics which assumes that all the market participants are utility optimizing and have rational expectations. Apart from that, it assumes that each market participant has complete knowledge of prices and market is purely competitive and operationally and informationally efficient. The presence of all these assumptions would ensure that market is allocating resources where it can generate highest possible return without need for any external influence.

If a market is efficient and there is no possibility of making abnormal returns, then there are no opportunities to benefit from asymmetrical information. Efficient market hypothesis predicts that a stock's price is equal to its fundamental value or intrinsic value as all the relevant information is reflected in stock's price. Hence the theory of EMH implies that fundamental analysis will not yield any excess returns if markets are efficient. Fundamental analysis is the process of obtaining the true or intrinsic value of the security after examination of the fundamental features of the security and company issuing security. The postulates of EMH also deny the possibility of earning any abnormal returns after conducting technical analysis. Technical analysis is the process of predicting stock returns from the past behavior of the security and market participants. However, empirical evidence suggests that participants have earned abnormal returns after fundamental and technical analysis. The paper explains the EMH in details and discusses the validity in real world.

Discussion

Market efficiency has become the basis of many financial models and investment strategies for many analysts and organizations. Technical analysts, who thrive on the irrationalness of the market, have faced a lot of criticism due to principles of efficient market hypothesis. Fundamental analysis and technical analysis are part of active portfolio strategy where analysts attempt to beat the market by scrutinizing the securities and including those securities in the portfolio whose intrinsic value in greater than their market value. Hence analysts try and find undervalued securities from a universe of securities and consider it an attractive investment because of the anticipation that price of security will converge to its intrinsic value. In the same manner overvalued securities are not an attractive investment as the fundamentals of the security imply a lower price in the future. Due to the popularity of efficient market hypothesis, passive management has become more applicable in modern era.

An efficient market suggests that price of security should equal intrinsic value of the ...