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Ch-11 EMH

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21 views14 pages

Ch-11 EMH

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tomerdushyant963
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Chapter-11

Efficient Market
Theory
Random Walk Theory

•Theory suggests that security prices fluctuations were


random.

•A follower of the random walk theory believes it's impossible


to outperform the market without assuming additional risk.

•The random walk hypothesis was studied—and debated—


intensively in the 1960’s.

•The random walk is explained by the efficient market


hypothesis (EMH)
Introduction
Efficient Market Hypothesis (EMH) is an idea partly developed in
the 1960s by Eugene Fama.
It states that it is impossible to beat the market because prices
already incorporate and reflect all relevant information.
An efficient capital market is one in which security prices
adjust rapidly to the arrival of new information and, therefore, the
current prices of securities reflect all information about the security.
According to the EMH, stocks 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.
•This is also a highly controversial and often disputed
theory.

•Supporters of this model believe it is pointless to search for


undervalued stocks or try to predict trends in the market
through fundamental analysis or technical analysis.

• Under the efficient market hypothesis, any time you buy and
sell securities, you're engaging in a game of chance, not skill.
If markets are efficient and current, it means that prices
always reflect all information, so there's no way you'll ever be
able to buy a stock at a bargain price.
ALTERNATIVE EFFICIENT MARKET HYPOTHESES

Fama divided the overall efficient market hypothesis


(EMH) and the empirical tests of the hypothesis into
three sub-hypotheses depending on the information set
involved:

(1) weak-form EMH

(2) semi-strong form EMH

(3) strong-form EMH.


1. Weak-Form EMH

 The weak-form EMH implies that the market is


efficient, reflecting all market information.
 This hypothesis assumes that the rates of return
on the market should be independent; past
rates of return have no effect on future rates.
 It states that current prices reflect all the
information found in past prices & traded
volumes.
Weak Form Tests (Price Information Tests)
The tests of the weak form of the EMH can be categorized as:
1.Statistical Tests for Independence - Weak-form EMH
assumes that the rates of return on the market are
independent.
o Examples of the tests are the autocorrelation tests (returns
are not significantly correlated over time) and runs tests
(stock price changes are independent over time).

2.Trading Tests - Weak-form EMH is that past returns are not


indicative of future results, therefore, the rules that traders
follow are invalid.
o An example of a trading test would be the filter rule, which
shows that after transaction costs, an investor cannot
earn an abnormal return.
2. Semi-Strong EMH
The semi-strong form EMH implies that the market is
efficient, reflecting all publicly available information.
This hypothesis assumes that stocks not only adjusts to
past prices but also adjust quickly to absorb new
information (earnings of corporations, dividends, bonus
issue, right issues, M&A etc.).
The semi-strong form EMH also incorporates the weak-
form hypothesis.
Given the assumption that stock prices reflect all new
available information and investors purchase stocks after this
information is released, an investor cannot benefit over and
above the market by trading on new information.
Semi-strong Form Tests (Other Information
Tests)
Given that the semi-strong form implies that the market is
reflective of all publicly available information, the tests of
the semi-strong form of the EMH are as follows:
1.Event Tests - The semi-strong form assumes that the
market is reflective of all publicly available information. An
event test analyzes the security both before and after an
event, such as earnings. The idea behind the event test is
that an investor will not be able to reap an above average
return by trading on an event.

2.Regression/Time Series Tests - a time series forecasts


returns based on historical data. As a result, an investor
should not be able to achieve an abnormal return using
this method.
3. Strong-Form EMH
The strong-form EMH implies that the market is
efficient: it fully reflects all information both
public and private, building and incorporating the
weak-form EMH and the semi-strong form EMH.

 Given the assumption that stock prices reflect all


information (public as well as private) no investor
would be able to profit above the average
investor even if he was given new information.
Strong-Form Tests (Inside Information Tests)

Given that the strong-form implies that the market is reflective of all
information, both public and private, the tests for the strong-form
center around groups of investors with excess information.
These investors are as follows:
1.Insiders - Insiders to a company, such as senior managers, have
access to inside information. SEBI regulations forbid insiders for
using this information to achieve abnormal returns.
2.Analysts - The equity analyst has been an interesting test. It
analyzes whether an analyst's opinion can help an investor
achieve above average returns. Analysts do typically cause
movements in the equities they focus on.
3.Institutional Money Managers - Institutional money managers,
working for mutual funds, pensions and other types of institutional
accounts, have been found to have typically not perform above
the overall market benchmark on a consistent basis.
Forms of the Efficient Market Hypothesis
•Tests of the market efficiency are essentially tests of whether
the three general types of information can be used to make
above-average returns on investments.

•In an efficient market, it is impossible to make above-average


return regardless of the information available, unless
abnormal risk is taken.

•Moreover, no investor or group of investors can consistently


outperform other investors in such a market.
Benefits of an Efficient Market (investors utility)
1.The market price will not stray too far from the
true economic price. This will avoid sudden, nasty
crashes in the future.
2. An efficient market increases liquidity, because
people believe the price incorporates all public
information, and thus they are less concerned about
paying way too much.
Market Inefficiencies

Some studies contradict the concept of market efficiency:

Overreaction of the market


Reversal to mean returns
Delayed absorption of new information
Low P/E Effect
Small firm effect
The weekend effect

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