Effcient market hypothesis

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Efficient market Hypothesis

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Effcient market hypothesis

  1. 1. Assignment on Efficient Market Hypothesis Gopi Raj Adhikari MBA Apex College 5th trimester Introduction Efficient market hypothesis(EMH) is an idea partly developed in the 1960s by Eugene Fama. An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information (investopedia.com). According to efficient market hypothesis, 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. EMH is highly controversial and often disputed because believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. The efficient markets hypothesis maintains that market prices fully reflect all available information. It can be predicted the market trend using two different techniques one is fundamental and another is technical analysis (investopedia.com). The efficient markets hypothesis (EMH) maintains that market prices fully reflect all available information. This idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioral economists who argue that the EMH is based on counterfactual assumptions regarding human behavior, that is, rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioral anomalies(L. Blume and S. Durlauf, 2007). Assumptions of Efficient Market Hypothesis: Large numbers of participant analyze and value securities independently Random fashion of new information regarding the securities and timing of new announcement is generally independent of others.
  2. 2. Investors adjust security prices rapidly to reflect the effects of new information. Value of EMH The following are the some of the values ofEfficient Market Hypothesis.It is important for the investors, company managers, and the government. The efficient market hypothesis refers to the idea of whether or not investors can consistently achieve market beating returns, depending on which form you accept. This is important for investors mostly because many investors attempt to beat the market by using market timing (charting & technical trading techniques) and fundamental analysis (reading annual reports & forecasting earnings, etc). The efficient market hypothesis says that these activities are a waste of time and that an efficient market already prices stocks at prices that already reflect all currently available information - thus making it impossible to beat the market. Three Level of EMH There are 3 different types of efficient market hypothesis they are as follows. Weak-form efficiency: It states that, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis does not produce the excess return but some fundamental analysis may provide some excess return. Share price does not have pattern to assets price (Wikipedia.com). Semi-strong-form efficiency: According to this, security price reflects all publicly available information i.e. economic news, political news, annual report etc. We cannot earn no excess earning from the trading on that information. Semi structure form efficiency implies that neither fundamental nor technical analysis can generate excess return (Wikipedia.com). Strong-form efficiency: according to this form of EMH, security price reflects all information i.e. public and private information. Private informationis not disclosed by the company and this information can earn excess return. Evidences FOR EMH
  3. 3. Since its introduction into the financial economics literature over almost 40 years ago, the efficient markets hypothesis has been examined extensively in numerous studies. The vast majority of this research indicates that stock markets are indeed efficient. In this section, we briefly discuss the evidence regarding the weak form, semi-strong form, and strong-form versions of the efficient markets hypothesis. The weak form of market efficiency, the random walk hypothesis implies that successive price movements should be independent. A number of studies have attempted to test this hypothesis by examining the correlation between the current return on a security and the return on the same security over a previous period. A positive serial correlation indicates that higher than average returns are likely to be followed by higher than average returns (i.e., a tendency for continuation), while a negative serial correlation indicates that higher than average returns are followed, on average, by lower than average returns (i.e., a tendency toward reversal). If the random walk hypothesis were true, we would expect zero correlation. Consistent with this theory, Fama (1965) found that the serial correlation coefficients for a sample of 30 Dow Jones Industrial stocks, even though statistically significant, were too small to cover transaction costs of trading. Subsequent studies have mostly found similar results, across other time periods and other countries. The Semi-strong Form the semi-strong form of the EMH is perhaps the most controversial, and thus, has attracted the most attention. If a market is semi-strong form efficient, all publicly available information is reflected in the stock price. It implies that investors should not be able to profit consistently by trading on publicly available information The Strong Form empirical tests of the strong-form version of the efficient markets hypothesis have typically focused on the profitability of insider trading. If the strong-form efficiency hypothesis is correct, then insiders should not be able to profit by trading on their privateinformation Evidences against EMH Although most empirical evidence supports the weak-form and semi-strong forms of the EMH, they have not received uniform acceptance. Many investment professionals still meet the EMH
  4. 4. with a great deal of skepticism. We will discuss some of the recent evidence against efficient markets. Over-reaction and Under-reaction: The efficient markets hypothesis implies that investors react quickly and in an unbiased manner to new information. Value versus growth: A number of investment professionals and academics argue that so called “value strategies” are able to outperform the market consistently. Typically, value strategies involve buying stocks that have low prices relative to their accounting “book” values, dividends, or historical prices. Small Firm Effect: He found that average returns on small stocks were too large to be justified by the Capital Asset Pricing Model, while the average returns on large stocks were too low. References Clarke ClJM. Efficient Markets Hypothesis, from http://e-m-h.org/ClJM.pdf Tanous, P, Investment Gurus, New York Institute of Finance, Englewood Cliffs, N.J.1997. J. Lakonishok, A. Shleifer, and R. Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance (December, 1994). S.P. Kothari, J. Shanken, and R. G. Sloan, “Another Look at the Cross-Section of Expected Stock Returns,” Journal of Finance ( March, 1995) F. Fama and K. French, “The cross-section of expected stock returns,” Journal of Finance (June, 1992) Efficient Market Hypothesis.investopedia. Efficient Market Hypothesis. (n.d) retrieved 2013/04/08, from yahoo.com Web Site: http://answers.yahoo.com/question/index?qid=20070414202343AA778O0

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