The efficient market hypothesis proposes that security prices reflect all available information. It comes in three forms: weak (only past prices), semi-strong (all public information) and strong (all information). Evidence supports weak and semi-strong forms, showing prices adjust to new public information. The hypothesis implies that fundamental analysis and technical analysis may not identify mispriced securities. It also provides support for low-cost index funds. While influential, the hypothesis makes assumptions and some strategies have achieved above-average returns.
2. 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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3. 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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4. 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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5. 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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6. 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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7. Market Reaction to an
unanticipated favorable event
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8. Market Reaction to anticipated
favorable event
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10. 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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11. 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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12. Why should price reflect available
information?
• If not, there would be arbitrage
opportunities
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13. 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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14. 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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15. 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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16. 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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17. 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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18. 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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19. 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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21. 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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22. 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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23. 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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24. 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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26. 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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27. 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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28. 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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29. 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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32. 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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33. 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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34. 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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