EFFICIENT MARKET HYPOSTHESIS

BCOM DSE 603 SEMESTER VI

FUNDAMENTALS OF INVESTMENT

By Sagarika

Assistant Professor
Department of Commerce

Patna Women’s College (Autonomous)

Email Id:sagarika.com@patnawomenscollege.in
Efficient Market Hypothesis

Market efficiency: -An efficient market is that provides fair return to its investors.
This is possible only when the market is able to quickly and accurately reflect the
expectation of investors in share prices, this is known as market efficiency.
Market efficiency signifies: how quickly and accurately” does relevant information
has its effect on the security prices. In an efficient market, all the known information is
immediately discounted by all the investors and reflected in the security prices in the
market. No single investor has an information edge over the others as everyone
knows all possible to know information simultaneously. Moreover, every investor
interprets the information similarly and behaves rationally.

According to E.F Fama “Efficient market is defined as the market where there are
large number of rational profit maximizers actively competing with each trying to
predict even the market value of individual securities and where current information is
almost freely available to all participants”.

“A market in which prices always fully reflect all available information is called
efficient”.

Efficient Market Theory was developed by University of Chicago professor Eugen Fama in the
1960s. As per this theory, at any given time, all available price sensitive information is fully
reflected in securities' prices. Thus, this theory implies that no investor can consistently
outperform the market as every stock is appropriately priced based on available information.
The efficient market hypothesis is a central idea of a modern finance that has profound
implications. An understanding of the efficient market hypothesis will help to ask the right questions
and save from a lot of confusion that dominates popular thinking in finance. An efficient market is
one in which the market price of a security is an unbiased estimate of its intrinsic value. Note that
market efficiency does not imply that the market price equals intrinsic value at every point in time.
Stating otherwise theory states that no one can "beat the market" hence making it impossible for
investors to either purchase undervalued stocks or sell stocks for inflated prices as stocks are
always traded at their fair value on stock exchanges. Hence it is impossible to outperform the
overall market through expert stock selection or market timing and that the only way an investor can
possibly obtain higher returns is by purchasing riskier investments.

Levels of Market efficiency

That price reflects all available information, the highest order of market efficiency.
According to FAMA, there exist three levels of market efficiency: -
Weak form efficiency – Price reflect all information found in the record of past
prices and volumes.
Semi – Strong efficiency – Price reflect not only all information found
in the record of past prices and volumes but also all other publicly
available information.
Strong form efficiency – Price reflect all available information public as well as
private information.

Weak form of EMH

The weak form of market holds that present stock market prices reflect all known information with
respect to past stock prices, trends, and volumes. This form of market holds that current prices of
stocks fully reflect all historical information; thus, past data cannot be used to predict future prices.
This form of theory is just the opposite of the technical analysis because according to it, the sequence
of prices occurring historically does not have any value for predicting the future stocks prices. The
technical analysts rely completely on charts and past behaviour of prices of stocks.

Implications of Weak form of EMH

1. Investors may still outperform the market & analyse stocks using fundamental analysis.

2. If the market is efficient in weak form, then technical analysis becomes a useless exercise

Semi-Strong Form of EMH

The semi strong form of the efficient market hypothesis centres on how rapidly and efficiently
market prices adjust to new publicly available information. In this state, the market reflects even
those forms of information which may be concerning the announcement of a firm s most recent
earnings forecast and adjustments which will have taken place in the prices of security. The investor
in the semi-strong form of the market will find it impossible to earn a return on the portfolio which is
based on the publicly available information in excess of the return which may be said to be
commensurate with the portfolio risk. Many empirical studies have been made on the semi-strong
form of the efficient market hypothesis to study the reaction of security prices to various types of
information around the announcement time of the information. Two studies commonly employed to
test semi-strong form efficient market are event study and portfolio study.
Implications of Semi -Strong form of EMH

1. If the market is efficient in semi-strong form, then technical analysis and fundamental
analysis also becomes a useless exercise.
2. Only those investors can outperform the market & earn superior returns who have access to
insider or private information.

Strong-Form of EMH

The strong-form efficient market hypothesis holds that all available information, public or private,
is reflected in the stock prices. The strong form is concerned with whether or not certain individuals
or groups of individuals possess inside information which can be used to make above average profits.
If the strong form of the efficient capital market hypothesis holds, then and day is as good as any
other day to buy any stock. This the most extreme form of the efficient market hypothesis. Most of
the research work has indicated that the efficient market hypothesis in the strongest form does not
hold good.

Challenges to the efficient market theory

a) Information inadequacy – Information is neither freely available nor rapidly transmitted to
all participants in the stock market. There is a calculated attempt by many companies to circulate
misinformation.
b) Irrational Behaviour – It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true. J.
M. Keynes argued that all sorts of consideration enter into the market valuation which is in no way
relevant to the prospective yield. This was confirmed by L. C. Gupta who found that the market
evaluation processes work haphazardly almost like a blind man firing a gun. The market seems to
function largely on hit or miss tactics rather than on the basis of informed beliefs about the long-term
prospects of individual enterprises.
d) Monopolistic Influence – A market is regarded as highly competitive. No
single buyer or seller is supposed to have undue influence over prices. In practice,
powerful institutions and big operators wield grate influence over the market. The
monopolistic power enjoyed by them diminishes the competitiveness of the market.
Random walk Theory

The random walk theory concept was propounded in 1973 when author Burton Malkiel coined the
term in his book "A Random Walk Down Wall Street. The Random walk theory firmly believes
that “stocks follows a random walk” i.e the successive price changes are random and
unpredictable. The basis of Random Walk Theory is that the market information is immediately
and fully spread so that all the investors have full knowledge of the information. As per this
theory, changes in stock prices are independent of each other. Therefore, it assumes the past
movement or trend of a stock price or market cannot be used to predict its future movement The
prices of today are independent the past trends. The price of each day is different it may be higher or
lower than the previous price or may be unchanged. The present price is randomly determined and is
influenced only by the information. As the equilibrium price of the security determined by demand
and supply forces based on available information, this equilibrium pre will immediately change as
fresh information becomes available. Based on the fret information, a new equilibrium prices will be
reached which is totally independent of the past price. The Random walk Theory totally
contradicts the technical analysis which believes the present prices are based on the past trends
and the history of trends repeats itself.

The Random walk Theory in its absolute form has the following assumptions:
1.There is a perfectly competitive market operating in an efficient manner.
2. Market is supreme and no individual investor or group can influence it.
3.All investors have the same information and nobody has superior knowledge so that the
prevailing market price reflects the stocks present value.
4. Institutional investors or major fund managers have to follow the market and cannot influence it
5. Future change in prices will only be as a result of some other new piece of information which was
not available earlier.
6.Market absorbs all the information quickly and efficiently.
7. Information is unbiased and correct.
8. Market players can analyse the information quickly and the information is absorbed in the market
through buy and sell signals.
9. Demand and supply pressures are absorbed in the market through price changes. Such absorption
leads to quick and prompt movements in prices which are random in fashion.

Price Earning Ratio

The equity shares are valued on the basis of earnings per share (EPS) and investors’ required
rate of return. This approach is largely used by equity investors in quickly valuing the equity
shares to make buy and sell decisions. The prevailing P/e ratio act as a guide in deciding the
investors’ required rate of return. It indicates the price investors are willing to pay for a rupee
of earning per share. The price earnings ratio the ratio of the market price per share to the
earnings per share:
PE = Market Price per share / Earnings per share

Types of P/E Ratio

1.Trailing Twelve Months (TTM) PE: TTM PE is the current share price divided by
the last 4 quarterly EPS.
2. Forward PE: Forward PE is the current share price divided by the projected EPS
over the next 4 quarters.