QUESTION ONE
An “efficient” market is defined as 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. 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. Now in an uncertain world the intrinsic value of a
security can never be determined exactly.
The efficient market hypothesis (EMH) is an investment theory that states that it is
impossible to "beat the market" because stock market efficiency causes existing share
prices to always incorporate and reflect all relevant information. 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 chance or by purchasing
riskier investments. 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 beimpossible to outperform the overall market
through expert stock selection or market timing, and the only way an investor can possibly
obtain higher returns is by purchasing riskier investments. Beyond the normal utility
maximizing agents, the efficient-market hypothesis requires that agents have rational
expectations; that on average the investors are correct and whenever new relevant
information appears, the agents update their expectations appropriately. Note that it is not
required that the agents be rational.
EMH allows that when faced with new information, some investors may overreact and
some may underreact. All that is required by the EMH is that investors' reactions be
random and follow a normal distribution pattern so that the net effect on market prices
cannot be reliably exploited to make an abnormal profit, especially when considering
transaction costs (including commissions and spreads). Thus, any one person can be wrong
about the market— indeed, everyone can be—but the market as a whole is always right.
There are three common forms in which the efficient-market hypothesis is commonly
stated—weak-form efficiency, semi-strong form efficiency and strong-form efficiency, each
of which has different implications for how markets work.
Required,
Provide a detailed technical and fundamental analysis of the three efficient-market
hypotheses
Financial markets which are said to be “information efficient” are according to the EMH. This
hypothesis maintains that there is no way to consistently beat the market on a risk-adjusted basis
because stock prices incorporate all the information. EMH is usually defined in the sense of
weak, semi and strong form of efficiency, all are related to the type of information reflected in
stock prices.
i. Weak-Form Efficiency
According to weak-form efficiency, all past trading information has already impacted not only
on stock prices but also on returns. This means that there is no way to make consistent excess
return using past price markets, volume data and other past historical financial data. With this
form technical analysis which is based on historical data patterns and trends for predicting the
future price movement is regarded as inefficacious in its task to achieve an advantage.
The weak form says that price changes are random, hence past price affects future stock prices.
However, this randomness, also known as a “random walk,” is that price changes are random.
This form holds that since all of past information is already priced in, only new information,
which in any event is random and unpredictable, can alter future prices.
ii. Semi-Strong Form Efficiency
Semi strong form efficiency suggests that all information, publicly available, is embedded in the
stock price, not just historical information. That means all current public information, earnings
reports, economic news, political events or any currently public information. Therefore, if
markets are semi-strong efficient, then there can be no consistent outperformance from
fundamental analysis, or technical analysis.
Fundamental analysis in finance is about using firm’s financial statements, management,
industry position, economics factors in order to determine a company’s intrinsic value and
making investment decisions. Nevertheless, if all the publicly available information is already
priced into the stock price, then any new information or announcement will result in a quick
price adjustment in the stock price, hence making it impossible for investors to take advantage of
the new information.
iii. Strong-Form Efficiency
The strong form efficiency states that all publicly available and private (inside information)
knowledge are completely incorporated into stock prices. Thus, it means that no one can earn
extra returns, including insiders with secret information. This version goes further to say that
even insider trading will not lead to superior profit.
The real world observations and legal restrictions are in contradiction with this form though, as
many high profile cases of insider trading have resulted in considerable gains. They argue that
strong form efficiency is really impossible to achieve in real world markets because of the
insider trading and information asymmetry issues in which some other market participants might
get the private information before it was public.
Empirical Tests and Criticism
One of the main tasks in testing for weak form efficiency is performing statistical tests on stock
returns such as autocorrelation and runs tests to see if past price data can predict future prices.
Event studies that measure how quickly stock prices respond to new public information have
been used for the purpose of semi strong form efficiency.
Most of these studies thus support the idea that stock prices quickly adjust, often within days, on
new information. The EMH is however challenged by anomalies such as the January effect and
momentum. In testing strong form efficiency, returns of insiders and market professionals
provide evidence often that insiders can realize abnormal profits contrary to strong form
assertions.
Practical Implications:
For EMH, it is a challenge for investors’ active management strategies. Actively managed funds
should not successfully out-perform passive index funds on a consistent basis after fees and
expenses, if markets are considered efficient. Therefore, this has caused it to also become
popular to use passive investing strategies and Index funds which was a way to mirror market
indices rather than outperform.
Although the idea of EMH is intuitive, behavioral finance like study of way psychological
factors influence investors, shows that markets sometimes are less than perfectly efficient, taking
into consideration irrational behavior and cognitive biases that make markets misprice.
Conclusion
The existence of each form of the hypothesis allows us to emphasize a peculiar aspect of market
efficiency or a specific level of applicability of market efficiency in the real world of investing.
As it relates to EMH, many studies support its validity in a weak and semi-strong form, yet
market anomalies are indicative of the fact that markets are not perfect. In that case, the impact
of passive and active strategies has to be understood from a nuanced standpoint: passive
strategies fulfill EMH requirements, but active ones may exploit market anomalies or
inefficiencies, mainly in imperfect markets, or when market stress strikes.
REFERENCES
Bocher, R. (2022). The intersubjective markets hypothesis. Journal of Interdisciplinary
Economics, Vol. 34 No. 1, pp. 35-50.
Cornell, B. (2019). What is the alternative hypothesis to market efficiency? The Journal of
Portfolio Management, Vol. 44 No. 7, pp. 3-6.
Malkiel, B. (2023). The efficient market hypothesis and its critics. Journal of Economic
Perspectives, Vol. 17 No. 1, pp. 59-82.
Shiller, R. (2020). From efficient markets theory to behavioral finance. The Journal of Economic
Perspectives, Vol. 17 No. 1, pp. 83-104.
