Efficient market hypothesis

Efficient Market hypothesis was developed by Professor Eugene Fama in 1960 and defined as a market where there are large numbers of rational, profit maximisers 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.

The efficient  market hypothesis states that at any given time and in a liquid market, security prices fully reflect all available information. Since share prices instantly reflect all the available information, then tomorrows prices are independent of todays prices and will only reflect tomorrows news. In this case, news and price changes are unpredictable. Therefore, both a novice and expert investor, holding a diversified portfolio, will obtain comparable returns regardless of their varying levels of expertise.

 ASSUMPTIONS UNDERLYING EFFICIENT MARKET HYPOTHESIS

The following assumptions are sufficient for an efficient market (Samuelson 1965)

Information is freely available to all market participants

All investor has the same time horizon

All investors have homogeneous expectation especially to the implication of current information for the current price and distribution of future prices of each security

No transaction cost for trading in securities.

Fama 1970 who developed the efficient market hypothesis has shown that the necessary conditions for an efficient market require much fewer restrictive assumptions such as :

Reasonable transaction cost for trading in securities

Information is available to a sufficient (large enough to influence price) numbers of investor

If expectations are heterogeneous, they are not systematically so,with a group of investors showing consistent superiority in assessing information and in capitalising  on it in the form of higher than average rate of return

FORMS OF EFFICIENT MARET HYPOTHESIS

Fama categorised the efficient market hypothesis in three forms

Weak form

Semi-strong form

Strong form

The weak form of EMH assumes that current stock prices fully reflect all currently available security market information. Which means that the weak form of EMH asserts that all past market prices and data are fully reflected in securities prices. In other words, Technical Analysis is of no use. Technical analysis believes that market prices exhibit identifiably patterns that are bound to be repeated. The study is based on the study of past price patterns without regard to any further background information.

To know how that the capital market is efficient in weak form, we can find out the correlation between the security prices overtime. In an efficient market there should not exist a significant correlation between securities price overtime. This means share prices behave randomly, the weak form of efficient is also referred to as the random walk hypothesis. This means that there should be successive price changes independently.

The semi-strong form of EMH assumes that current stock prices adjust rapidly to the release of all new public information. It contends that security prices have factored in available market and non-market public information. It says that the market will quickly digest the publication of relevant new information by moving the price to a new equilibrium level that reflects the change in supply and demand caused by the emergence of that information.

It concludes that excess returns cannot be achieved using fundamental analysis.

Fama, Fisher, Jensen and Roll (1969). They use the stock splits (a well published event) as an information generating event if the market is efficient, all information communicated by stock priced split should be recognised at the time of the split and subsequent stock prices should  not show any unusual tendency to rise or fall

The strong form of EMH assumes that current stock prices fully reflect all public and private information. It contends that market, non-market and inside information is all factored into security prices and that no one has monopolistic access to relevant information. It assumes a perfect market and concludes that excess returns are impossible to achieve consistently. For example, if the current market price is lower than the value justified by some piece of privately held information, the holders of that information will exploit the pricing anomaly by buying the shares. They will continue doing so until this excess demand for the shares has driven the price up to the level supported by their private information. At this point they will have no incentive to continue buying, so they will withdraw from the market and the price will stabilise at this new equilibrium level.

However, whether the information is in the public domain or not. As we have seen, this implies that excess returns cannot consistently be achieved even by trading on inside information. This does prompt the interesting observation that somebody must be the first to trade on the inside information and hence make an excess return.

Empirical tests of strong form of efficient market hypothesis are of two type the first type of the test involve examine the performance of individual or group who can be identified as able to possess  non-public information. This test is concerned with whether some institution possess superior ability ti earn an excess profit. The second type of test attempt to find whether excess return arises directly from inside (non-public) information. Jensen (1968) examined the performance of mutual funds. he concluded that the mutual funds on the average, were not able to outperform the market. This tends to show that the strong form of efficient market hypothesis hold.

Jaffe (1974), Finnerty (1976), Reilly and Drzycimski (1975) among others researchers concluded that insiders or specialist who have privileged access to information can outperform the market. Thus it also appears that the strong form of efficient market hypothesis does not hold

Criticism of the Theory

The critics of this theory point out that only a few individuals are as rational as it presumes them to be, and that information gathering is expensive and tedious enough to make it unlikely to be reflected in the prices. Many declare the anomalies have been detected in patterns of historical share prices. The best known of these are the small firm effect and the January effect and the mean reversion 

Conclusion

In conclusion, efficient market hypothesis state that an investor cannot make excess returns out of stale information, but the calculation of an excess return depend also on an accurate assessment of the risk associated with holding a share . Despite all work done in this area since 1960, there is still no single, universally accepted r objectively verified method of risk in the context of investment holding.

 The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyse securities. In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.