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Market efficiency and Efficient Market hypothesis

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ABV-Indian Institute of Information Technology and
Management, Gwalior
Ravindra Nath Shukla
Research Scholar
Market Efficiency
and
Efficient Market Hypothesis
Source credit : Investopedia
What Is Market Efficiency?
 Market efficiency refers to a market where
prices represent all relevant financial
information about an underlying asset or
security.
 The more information that all market players
will have, the more efficient the market is.
 It, thus, provides an equal opportunity for buyers
and sellers to execute trades and make profits
while minimizing transaction costs.
Source credit : WallstreetMajo
Key Takeaways
 The market efficiency occurs when current market prices reflect
all relevant financial information about an underlying asset or
security.
 The more information available to all market participants, the
more efficient the market becomes. Access to the same data
makes investors unable to predict prices and outperform the
market.
 An efficient market gives equal opportunity for buyers and
sellers to profit in a liquid and highly competitive market while
minimizing transaction costs, the likelihood of arbitrage, and
above-market gains.
 The concept is linked to American economist Eugene Fama’s
efficient market hypothesis in 1970 and is useful in commercial
and financial scenarios.
Forms of Market Efficiency
 #1 – Weak Market Efficiency
 #2 – Semi-Strong Market Efficiency
 #3 – Strong Market Efficiency
Source credit : WallstreetMajo

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Market Efficiency.pptx

  • 1. ABV-Indian Institute of Information Technology and Management, Gwalior Ravindra Nath Shukla Research Scholar Market Efficiency and Efficient Market Hypothesis
  • 2. Source credit : Investopedia
  • 3. What Is Market Efficiency?  Market efficiency refers to a market where prices represent all relevant financial information about an underlying asset or security.  The more information that all market players will have, the more efficient the market is.  It, thus, provides an equal opportunity for buyers and sellers to execute trades and make profits while minimizing transaction costs.
  • 4. Source credit : WallstreetMajo
  • 5. Key Takeaways  The market efficiency occurs when current market prices reflect all relevant financial information about an underlying asset or security.  The more information available to all market participants, the more efficient the market becomes. Access to the same data makes investors unable to predict prices and outperform the market.  An efficient market gives equal opportunity for buyers and sellers to profit in a liquid and highly competitive market while minimizing transaction costs, the likelihood of arbitrage, and above-market gains.  The concept is linked to American economist Eugene Fama’s efficient market hypothesis in 1970 and is useful in commercial and financial scenarios.
  • 6. Forms of Market Efficiency  #1 – Weak Market Efficiency  #2 – Semi-Strong Market Efficiency  #3 – Strong Market Efficiency Source credit : WallstreetMajo
  • 7. Source credit : WallstreetMajo
  • 8. #2 – Semi-Strong form  The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading on that new information.  It indicates that current prices consider all publicly available information about an asset or security.  It also offers previous price details. As a result, it discourages investors from benefitting above the market by trading on the inside information.  This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve superior returns.  Any information gained through fundamental analysis will already be available and thus already incorporated into current prices.  Only private information unavailable to the market at large will be useful to gain an advantage in trading, and only to those who possess the information before the rest of the market does.
  • 9. #1 – Weak form  This form reveals all past information about asset or security pricing.  The weak form of market efficiency is that past price movements are not useful for predicting future prices.  The past pricing details reflected in current prices are insufficient to assist investors in determining correct future trading prices.  If all available, relevant information is incorporated into current prices, then any information relevant information that can be gleaned from past prices is already incorporated into current prices.  As a result, the weak form market efficiency will only result in asset undervaluation or overvaluation, affecting trade decisions.  Future price changes can only be the result of new information becoming available
  • 10. #3 – Strong form  The strong form of market efficiency says that market prices reflect all information both public and private.  It is the result of combining weak and semi-strong forms.  This form shows market prices based on all accessible information (public, insider, and private).  This insider knowledge, however, is neutral and available to all traders.  As a result, despite having access to insider information , it ensures that all investors profit equally.
  • 11.  The Efficient Market Hypothesis (EMH) states that the stock asset prices indicate all relevant information very quickly and rationally.  Such information is shared universally, making it impossible for investors to earn above-average returns consistently.  The assumptions of this theory are criticized highly by behavioral economists or others who believe in the inherent inefficiencies of the market. Efficient Market Hypothesis
  • 12. Source credit : WallstreetMajo
  • 13. Let us look at some assumptions of the efficient market hypothesis theory.  Investors in the market may act rationally or normally.  If there is unusual information, the investor will react unusually.  Which is normal behavior, or doing what everyone else is doing is also considered normal behavior.  The stock price indicates all the relevant information shared universally among the investors.  It also states that the investors cannot exploit the market since they need to act as per the market information and make decisions accordingly. Assumptions Of EMH
  • 14.  Economist Eugene Fama gave the efficient market hypothesis in the 1970s.  According to this hypothesis, the efficient market will not provide any profitable opportunity for trading.  Thus, attaining a superior return consistently in such a condition is impossible.  Time is an essential factor within which the market spreads information.  This time gap provides traders the opportunity to exploit the inefficiency. Efficient Market Hypothesis
  • 15. Examples of Market Efficiency Example #1  Assume that companies A and B are up for takeover  These companies’ stock values are lenient and stable for a few days, with only minor fluctuations.  However, as soon as it was announced that a well-known corporation would be taking over both of them, their stock prices jumped. ABC Ltd. B A
  • 16.  In this instance, the takeover announcement adds new information to the current data for the companies’ stocks.  Resulting in a price change.  As a result, the rise in stock prices indicates new positive information to the companies.
  • 17. Example 2  Mary, a trader, is looking forward to purchasing stocks at a reduced price on one market and selling them at a higher price on another market.  This type of trading, known as arbitrage.  Arbitrage is the process of profiting from a pricing discrepancy.  Unfortunately, even though an arbitrager can make a risk- free return in this situation, the market’s overall efficiency suffers.  As a result, markets prohibit arbitrage and impose restrictions on acts that impede market efficiency.
  • 18. Example 3  Suppose a person named Johnson holds 900 shares of an automobile company, and the current price of these shares trades at $156.50.  Johnson had some relations with an insider of the same company who informed Johnson that the company had failed in their new project and the price of a share would decline in the next few days.
  • 19.  Johnson had no faith in the insider and held all his shares. Then, after a few days, the company announces the project’s failure, dropping the share price to $106.00.  The market modifies the newly available information.  To realize the gross gain, Johnson sold his shares at $106.00 and a gross gain of $95,500.  If Johnson had sold his 900 shares at $156.50 earlier by taking the insider’s advice, he would have earned $140,850.  So, his loss for the sale of 900 shares is $140,850-$95,500 i.e., $45,350.
  • 20. Importance  This theory takes into account the fact that there are always some special cases or outliers.  Who are able to use the time gap between the old pices and change in price due to new information to earn extra return.  The importance of efficient market hypothesis also lies in the fact that it is useful in the asset pricing models.  There is no need of government intervention since stock prices adjust automatically.
  • 21. Criticism  One of the biggest reasons behind the criticism of the efficient market hypothesis is market bubbles  If such assumptions were correct, there was no possibility of bubbles and crashing incidents.  Such as stock market crash and housing bubbles in 2008 or,  the tech bubble of the 1990s.  Such companies were trading at high values before hitting.  Thus, this criticism is an important argument for efficient market hypothesis testing. Existence of Market Bubbles:
  • 22. Wins against the Market:  Some investors, such as Warren Buffett, won against the market consistently.  He had consistently earned above- average profit from the market for over 50 years through his value investing strategy.  On the other hand, some behavioral economists also highly criticize the efficient market hypothesis theory because  they believe that past performances help predict future prices.
  • 23. Efficient Market Hypothesis Vs Behavioral Finance  Efficient market hypothesis states that markets are efficient since information quickly spreads  whereas behavioral finance states that investors tend to be irrational in their judgement.  Following are the key differences of Efficient Market Hypothesis Vs Behavioral Finance.
  • 24. Efficient Market Hypothesis Behavioral Finance It states that market is in equilibrium since information spreads quickly. It states that due to behavioral differences, market may not be in equilibrium. Investors are always unbiased. It states that investors may be use their bias while investing. It makes market unpredictable. Irrationality tend to make investors try and predict the market. No planned approach/ is possible. Investors try to make a planned approach.
  • 25.  Ravindra Nath Shukla  ravisky1989@gmail.com ravindra@iiitm.ac.in  Slide share : ravisky1989