IA&M Module-3

Efficient Market Hypothesis

 Introduction
 Random walk hypothesis
 The efficient market hypothesis (EMH) is an idea partly developed in the
1960s by Eugene Fama.
 It is an investment theory that states it is impossible to "beat the market"
because stock market efficiency causes existing shares to always
incorporate and reflect all relevant information.
 According to the EMH, stock always trade at their fair value on stock
exchanges, making it impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices. As such, it should be
impossible to outperform the overall market through expert stock
selection or market timing, and that the only way an investor can
possibly obtain the higher returns is by purchasing riskier investments.
 An efficient capital market is a market that is efficient in
processing information.
 In other words, the market quickly and correctly adjusts to
new information.
 In an information of efficient market, the prices of securities
observed at any time are based on “correct” evaluation of all
information available at that time.
 Therefore, in an efficient market, prices immediately and fully
reflect available information.
Definition
• "In an efficient market, competition among the many
intelligent participants leads to a situation where, at any point
in time, actual prices of individual securities already reflect the
effects of information based both on events that have already
occurred and on events which, as of now, the market expects to
take place in the future. In other words, in an efficient market
at any point in time the actual price of a security will be a
good estimate of its intrinsic value."
- Eugene Fama,
The Efficient Markets Hypothesis
 The Efficient Markets Hypothesis (EMH) is made up of three
progressively stronger forms:
 Weak Form
 Semi-strong Form
 Strong Form
 The EMH Graphically
 In this diagram, the circles All historical prices and returns
represent the amount of
information that each form of the Strong Form
EMH includes.
 Note that the weak form covers the Semi-Strong
least amount of information, and
the strong form covers all
Weak Form
information.
 Also note that each successive form
includes the previous ones.

All information, public and private

All public information
The Weak Form
 The weak form of the EMH says that past prices, volume, and
other market statistics provide no information that can be used to
predict future prices.
 Weak because security prices are the most easily available piece of
information.
 Many financial analysts attempt to generate profits by studying
exactly what this hypothesis asserts is of no value - past stock price
series and trading volume data. This technique is called technical
analysis.
 Prices should change very quickly and to the correct level when
new information arrives (see next slide).
 This form of the EMH, if correct, repudiates technical analysis.
The Semi-strong Form
 The semi-strong form says that prices fully reflect all publicly
available information(even those reported in the financial
statements of the companies) and expectations about the future.
 This suggests that prices adjust very rapidly to new information,
and that old information cannot be used to earn superior returns.
 The assertion behind semi-strong market efficiency is still that one
should not be able to profit using something that “everybody else
knows” (the information is public). Nevertheless, this assumption
is far stronger than that of weak-form efficiency.
 The semi-strong form, if correct, repudiates fundamental analysis.
The Strong Form
 The strong form says that prices fully reflect all information,
whether publicly available or not.
 Even the knowledge of material, non-public information
cannot be used to earn superior results.
 The rationale for strong-form market efficiency is that the
market anticipates, in an unbiased manner, future
developments and therefore the stock price may have
incorporated the information and evaluated in a much more
objective and informative way than the insiders
 Most studies have found that the markets are not efficient in
this sense.
Summary of Tests of the EMH
 Weak form is supported, so technical analysis cannot consistently
outperform the market.
 Semi-strong form is mostly supported , so fundamental analysis
cannot consistently outperform the market.
 Strong form is generally not supported.
 Ultimately, most believe that the market is very efficient, though
not perfectly efficient. It is unlikely that any system of analysis
could consistently and significantly beat the market (adjusted for
costs and risk) over the long run.
Anomalies
CALENDAR EFFECTS
 Anomalies that are linked to a particular time are called calendar
effects.
 Weekend Effect : The tendency of stock prices to decrease on
Mondays.
 Turn-of-the-month effect: The turn-of-the-month effect refers to
the tendency of stock prices to rise on the last trading day of the
month and the first three trading days of the next month.
 Turn-of-the-Year Effect: The turn-of-the-year effect describes a
pattern of increased trading volume and higher stock prices in the
last week of December and the first two weeks of January.
ANNOUNCEMENTS AND INFORMATION
 Stock split effect
 Short-term price drift
 Merger Arbitrage
SUPERSTITIOUS INDICATORS
 Muharrat Trading
 Superbowl Indicator
Implications of Efficient Markets

 Technical Analysis – Technical analysis uses past patterns of

price and the volume of trading as the basis for predicting
future prices. Evidence suggests that prices of securities are
affected by news. Favourable news will push up the price and
vice versa. It is therefore appropriate to question the value of
technical analysis as a means of choosing security
investments.
 Fundamental Analysis – Fundamental Analysis
involves using market information(such as earnings , dividends ,
accounting ratios) to determine the intrinsic value of securities in
order to identify those securities that are undervalued. However
semi strong form market efficiency suggests that fundamentals
analysis cannot be used to outperform the market. In an efficient
market, equity research and valuation would be a costly task that
provided no benefits. The odds of finding an undervalued stock
should be random (50/50). Most of the time, the benefits from
information collection and equity research would not cover the
costs of doing the research.
 Optimal Investment Strategy - For optimal investment
strategies, investors should follow a passive investment strategy,
which makes no attempt to beat the market. Investors should
not select securities according to their risk aversion or tax
positions . In an efficient market, it would be a superior
strategy to have a random diversification across securities,
carrying little or no information cost and minimal execution
costs in order to optimise the returns. There would be no
value added by portfolio managers and investment strategists
.
 The overall assumption is that no investor is able to generate
an abnormal return in the market. If that is the case, an
investor can expect to make a return equal to the market
return. An investor should thus focus on the minimizing his
costs to invest. To achieve a market rate of return,
diversification in a numerous amounts of stocks is required,
which may not be an option for a smaller investor. As such,
an index fund would be the most appropriate investment
vehicle, allowing the investor to achieve the market rate of
return in a cost effective manner.