Efficient market Hypothesis

1. Efficient Market Hypothesis

2. Introduction
 Random walk hypothesis
 The efficient market hypothesis (EMH) is an idea partly
developed in the 1960s by Eugene Fama.
 It is an investment theory that states it is impossible to
"beat the market" because stock market efficiency causes
existing shares to always incorporate and reflect all
relevant information.
 According to the EMH, stock 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 be impossible to
outperform the overall market through expert stock
selection or market timing, and that the only way an
investor can possibly obtain the higher returns is by
purchasing riskier investments.

3.  An efficient capital market is a market that is efficient
in processing information.
 In other words, the market quickly and correctly
adjusts to new information.
 In an information of efficient market, the prices of
securities observed at any time are based on
“correct” evaluation of all information available at that
time.
 Therefore, in an efficient market, prices immediately
and fully reflect available information.

4. Definition
• "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."
- Eugene Fama,

5. The Efficient Markets Hypothesis
 The Efficient Markets Hypothesis (EMH) is made
up of three progressively stronger forms:
 Weak Form
 Semi-strong Form
 Strong Form

6. The EMH Graphically
 In this diagram, the circles
represent the amount of
information that each form of
the EMH includes.
 Note that the weak form
covers the least amount of
information, and the strong
form covers all information.
 Also note that each
successive form includes the
previous ones.
Strong Form
Semi-Strong
Weak Form
All information, public and private
All public information
All historical prices and returns

7. The Weak Form
 The weak form of the EMH says that past prices,
volume, and other market statistics provide no
information that can be used to predict future prices.
 Weak because security prices are the most easily
available piece of information.
 Many financial analysts attempt to generate profits by
studying exactly what this hypothesis asserts is of no
value - past stock price series and trading volume
data. This technique is called technical analysis.
 Prices should change very quickly and to the correct
level when new information arrives (see next slide).
 This form of the EMH, if correct, repudiates technical
analysis.

8. The Semi-strong Form
 The semi-strong form says that prices fully reflect all
publicly available information(even those reported in
the financial statements of the companies) and
expectations about the future.
 This suggests that prices adjust very rapidly to new
information, and that old information cannot be used
to earn superior returns.
 The assertion behind semi-strong market efficiency is
still that one should not be able to profit using
something that “everybody else knows” (the
information is public). Nevertheless, this assumption
is far stronger than that of weak-form efficiency.
 The semi-strong form, if correct, repudiates
fundamental analysis.

9. The Strong Form
 The strong form says that prices fully reflect all
information, whether publicly available or not.
 Even the knowledge of material, non-public
information cannot be used to earn superior
results.
 The rationale for strong-form market efficiency is
that the market anticipates, in an unbiased
manner, future developments and therefore the
stock price may have incorporated the
information and evaluated in a much more
objective and informative way than the insiders
 Most studies have found that the markets are not
efficient in this sense.

10. Summary of Tests of the EMH
 Weak form is supported, so technical analysis cannot
consistently outperform the market.
 Semi-strong form is mostly supported , so
fundamental analysis cannot consistently outperform
the market.
 Strong form is generally not supported.
 Ultimately, most believe that the market is very
efficient, though not perfectly efficient. It is unlikely
that any system of analysis could consistently and
significantly beat the market (adjusted for costs and
risk) over the long run.

11. Anomalies
CALENDAR EFFECTS
 Anomalies that are linked to a particular time are
called calendar effects.
 Weekend Effect : The tendency of stock prices to
decrease on Mondays.
 Turn-of-the-month effect: The turn-of-the-month effect
refers to the tendency of stock prices to rise on the
last trading day of the month and the first three
trading days of the next month.
 Turn-of-the-Year Effect: The turn-of-the-year effect
describes a pattern of increased trading volume and
higher stock prices in the last week of December and
the first two weeks of January.

12. ANNOUNCEMENTS AND INFORMATION
 Stock split effect
 Short-term price drift
 Merger Arbitrage

13. SUPERSTITIOUS INDICATORS
 Muharrat Trading
 Superbowl Indicator

14. Implications of Efficient Markets
 Technical Analysis – Technical analysis uses past
patterns of price and the volume of trading as the
basis for predicting future prices. Evidence
suggests that prices of securities are affected by
news. Favourable news will push up the price and
vice versa. It is therefore appropriate to question
the value of technical analysis as a means of
choosing security investments.

15.  Fundamental Analysis – Fundamental Analysis
involves using market information(such as earnings ,
dividends , accounting ratios) to determine the
intrinsic value of securities in order to identify those
securities that are undervalued. However semi strong
form market efficiency suggests that fundamentals
analysis cannot be used to outperform the market. In
an efficient market, equity research and valuation
would be a costly task that provided no benefits. The
odds of finding an undervalued stock should be
random (50/50). Most of the time, the benefits from
information collection and equity research would not
cover the costs of doing the research.

16.  Optimal Investment Strategy - For
optimal investment strategies, investors should
follow a passive investment strategy, which
makes no attempt to beat the market. Investors
should not select securities according to their risk
aversion or tax positions . In an efficient market,
it would be a superior strategy to have a random
diversification across securities, carrying little or
no information cost and minimal execution costs
in order to optimise the returns. There would be
no value added by portfolio managers and
investment strategists .

17.  The overall assumption is that no investor is able
to generate an abnormal return in the market. If
that is the case, an investor can expect to make a
return equal to the market return. An investor
should thus focus on the minimizing his costs to
invest. To achieve a market rate of return,
diversification in a numerous amounts of stocks is
required, which may not be an option for a
smaller investor. As such, an index fund would be
the most appropriate investment vehicle, allowing
the investor to achieve the market rate of return in
a cost effective manner.