EFFICIENT MARKET THEORY AND TESTS
A market is said to be efficient if prices in that market reflect all available information. Market efficiency refers to a condition in which current stock prices reflect all the publicly available information about a security. Efficient market emerges when new information is quickly incorporated into the share price so that the price becomes information. In other words the current market price reflects all available information. Under these conditions the current market price in any financial market could be the best (unbiased estimate) of the value of the investment. The Theory of Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) was first defined by Eugene Fama in his financial literature in 1965.He defined the term "efficient market" as one in which security prices fully reflects all available information. EMH is the theory describing the behavior of an assumed “perfect” market which states that: Securities are fairly priced and that their expected returns equal their required return. Security prices, at any one point, fully reflect all public information available and react swiftly to new information. Because stocks are fully and fairly priced, investors need not waste time trying to find and capitalize on mispriced (undervalued and overvalued) securities. Therefore, the market is efficient if the reaction of market prices to new information should be instantaneous and unbiased. The efficient market hypothesis states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknown in the present and thus appears randomly in the future. Evidence in favor Efficient Market Hypothesis Theory
i. Stock prices are close to random walks
ii. Stock returns have low linear correlation
iii. Stock returns are very hard to predict
iv. Portfolio managers do not beat the market on average and almost no one beats the market consistently.
Assumptions on the Market Efficiency
i. Information is available and all investors have access to the available information about the future ii. All investors pay close attention to market price and adjust their portfolio appropriately iii. All of information is fully and immediately reflected in market prices iv. Investors make a fair return on their investments
v. Investors believe that the market is not efficient, investors spend time analyzing securities searching for undervalued securities and consequently security prices react instantaneously to released information, which in turn makes the market efficient.
Forms of Market Efficiency
There are three common forms in which the efficient market theory is commonly stated. They include:The weak form, the semi strong form and the strong form.
i) Weak Form of Efficient Market
The weak form EMH stipulates that current asset prices already reflect past price and volume information. The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that "everybody else knows".
This technique is so called technical analysis that is asserted by EMH as useless for predicting future price changes.
It asserts that it should be possible to predict future stock price movement from historical patterns e.g. if a company's Stock at NSE has increased steadily over the past few months to the current price of Ksh.30, then this price will already fully reflect the information about the company's growth and therefore the next change in the stock price could either be upward, downward, or constant with equal probability. It...
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