Efficient Market Hypothesis

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How can we forcast price of share?

• Fundamental Analysis• Technical Analysis

• Market price of the share is not only dependent on demand and supply but several other factors – can be termed as INFORMATION.

• The perceptual inferences of all information available in the market, if quantified accurately should help in predicting the expected price of the securities.

• This has been advocated thro’ informal market efficiency theory.

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History

• Developed by Professor Eugene Famaat the University of Chicago Booth School of Business.

• The efficient-market hypothesis was first expressed by Louis Bachelier, a French mathematician, in his 1900 dissertation, "The Theory of Speculation".

• The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists.

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Why Efficient Market Hypothesis?

• To test the form of market – extent of efficiency.

• To make sure that one can accurately forecast the

market, discover the market trend and help investors to

make critical decisions.

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The most important consequences of this

hypothesis is that it is not possible to outperform the

market (adjusted for risk) over the long term

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What is Efficient Market?

• A market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants

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Market Reaction to an unanticipated favorable event

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Market Reaction to anticipated favorable event

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Monday Effect..

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Efficient Market Hypothesis

• Securities prices always fully reflect all available, relevant information about the security.

• Note the key words of the definition: “always,” “fully,” and “information.”

• Two important questions– What is all available information?– What does it mean to “Reflect all available information?”

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All available information

• Past Price : Weak Form• All public information : Semi Strong Form

– Past price, news etc..• All information including inside information

: Strong Form

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Why should price reflect available information?

• If not, there would be arbitrage opportunities

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Early thinking about securities market prices

(early 20th century):

• Observers noticed that the charts that tracked the pattern of stock market prices looked similar to a chart of a random event, such as tossing a coin and marking an increase if you get a “heads,” or a decrease if you get a “tails.”

• They wondered why the stock market behaved like a random walk.

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Important!

• The actual stock price was not seen to be random, only

the CHANGE in the price appeared to be random in

occurrence.

• In particular, using valuation theory, it should be true that

a common stock sells for a price that is the present value

of all the future cash flows (dividends) expected by

investors.

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What would cause a stock price to change?

• A reasonable answer is that the price would change if investors obtain new information about the stock that causes them to revise their forecast about the stock’s future return.

• New information that causes investors to be more optimistic would cause them to revalue the stock price higher. Negative information would result in lower price revaluations.

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Since new information arrives in the market in an unpredictable (random) fashion, prices will

change randomly as well.

• Conclusion: New information is the cause of securities price changes. Since one cannot predict whether the next piece of new information will be favorable or unfavorable for a stock, the future changes in stock prices are similarly unpredictable.

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Much empirical research has been done to examine how much (or how fully) information is incorporated in market prices.

• Questions about the extent of the information incorporated has led to several terms to describe the degree of efficiency exhibited in a particular market.

• The three terms are “weak form efficient,” “semi-strong form efficient,” and “strong form efficient.”

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The weak form efficient markets hypothesis - a definition, and

some evidence:

• The weak form hypothesis maintains that past stock price changes cannot be used to earn above average profits. (Because this information is available to all, and thus, already incorporated in market price.)

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Weak form evidence:• Studies show that systems that try to predict the future

course of stock prices based upon some rule derived from the history (past days, weeks, or months) of past stock price changes do not make profit greater than a simple buy and hold strategy.

• Statistical analysis of successive stock price changes reveals that the correlation between price changes is approximately zero.

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Weak Form

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If a market is weak form efficient, then technical analysis should

not be effective in picking stocks for above average profits.

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Despite the evidence for market efficiency, there are many

professional investors who claim that technical analysis can be

effective. Such claims are largely unproven, but it shows that not everyone accepts the efficient

market hypothesis.

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The semi-strong form efficient markets hypothesis - a definition

and some evidence:

• The semi-strong form efficient markets hypothesis maintains that all publicly available information is incorporated in stock prices.

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Semi-strong form evidence:

• Studies show that public announcements of earnings, dividends, stock splits, etc. cause stock prices to immediately change to reflect the new information.

• Studies show that mutual funds (whose professional managers would be expected to have access to the very best information available) do not consistently outperform the average market indexes.

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If a market is semi-strong efficient, then picking stocks based on publicly available

information, should not yield profits greater than what could be obtained using a simple buy

and hold strategy.

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Evidence of efficient markets has given great impetus to the

formation of “Index Funds,” for investors wanting to minimize

research costs and trading costs while investing in a mutual fund

that closely tracks a given market index.

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The strong form of the efficient markets hypothesis - a definition

and some evidence:

• The strong form of the hypothesis maintains that all information obtainable from any source whatever, is incorporated in market prices.

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Strong form evidence:

• Studies show that “inside information” available to corporate insiders or market specialists could be used to earn above average trading profits

• Yet, remember that using inside information is illegal!. Thus, strong form inefficient markets may not be legally exploited to earn greater than average profits, either.

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In conclusion:

• There is evidence that markets are weak form and semi- strong form efficient, but probably not strong form efficient.

• Yet it must be noted that the tests of efficiency have largely focused on well developed markets in the United States. Foreign markets have been studied less extensively, and may exhibit less efficiency. This is especially true of markets in less developed countries (sometimes called “emerging” markets).

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Finally, it should be noted that there is some evidence that contradicts the hypothesis.

• Some market studies give evidence that a strategy as simple as buying low P/E ratio stocks can result in above average profit.

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The efficient market hypothesis has not been “proven,” however, it is a highly regarded tenant in

modern finance.

• If markets are efficient, investors can expect that prices are “fair,” and that the rate of return earned from a diversified portfolio of securities over time will be approximately average for that class of securities.

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