Capital Market Analysis: a Dicussion on Efficient Market Hypothesis

Topics: Stock market, Investment, Financial markets Pages: 10 (3400 words) Published: July 30, 2006
Answer to Question 1:
Efficient Market Hypothesis was firstly brought forward by E. Fama in 1960s. Its main believing is in that security prices fully reflect all available information in an efficient market, which allows investors to earn no above average risk-adjusted return (Fama, 1965). Although some technical studies and opportunistic investors have stretched hard in searching for proofs to challenge the efficient market hypothesis, and to prove above average returns could be gained by predicting the future price using the existing information, their efforts result only in finding of the ¡®anomalies¡¯ in the market which are destined to self-destructing in the long run or being proved worthless taken the transaction cost. Accepting the ideas of efficient market hypothesis and based on the collective effort of Sharpe, Treynor, Lintner, and Mossin (see Perold, 2004), Capital Asset Pricing Model (CAPM) was developed in 1960s as a modified form of Sharpe Ratio in evaluating financial assets returns and prices versus risks in the form of: E (ri) = rf + ¦Âi [ E(rm) ¨Crf ] .

From the CAPM model, Jensen (1968) derive his risk-adjusted measure of portfolio performance (now known as "Jensen's Alpha").The formula given below demonstrates the function of ¦Á, and is used to determine the excess return (the amount by which the portfolio's actual return deviates from its expected return). Like Treynor, Jenson also considered only the un-diversifiable risk, assuming that the portfolio eliminates the diversifiable risk. ri = ¦Á + rf + ¦Âi [ E(rm) ¨Crf ] = ¦Á + E (ri) ¦Á = ri ¨C rf ¨C ¦Âi [ E(rm) ¨Crf ] ¦Á here is named as Jensen¡¯s Alpha, as illustrated in diagram:

This measure indicates the difference between the portfolio's actual return and its expected return. According to efficient market hypothesis, the portfolio return should be on the SML, which means Jensen¡¯s alpha is supposed to be zero and that indicates the portfolio was able to earn just its expected return. According to the empirical research The Performance of Mutual Funds in the Period 1945-1964(1968), Jensen found that the average ¦Á of the 115 mutual funds¡¯ performance over the period is negative, which means that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance (while random chosen portfolios may have ¦Á at least equal to zero) (Jensen, 1968). By this means, it could echo the CAPM model and perform as strong evidence of the efficient market hypothesis, by which no above average profit could be earned given risk level.

Answer to Question 2:
Malkiel believes that financial markets can reflect new information rapidly, for the most part, accurately. And he believes that such markets do not allow investors to earn above-average returns without accepting above-average risks. Although he do not deny that the market pricing is not always perfect, nor does he disagree that some psychological factors influence securities prices. He still believes that in and overall and long-term view, financial market is efficient for the following reasons: First, Malkiel distinguished statistical significance from economic significance, arguing that the statistical significance giving rise to momentum are extremely small and cannot last long. Also the large amount of transaction cost of exploring the momentum will offset the benefit gained, therefore inferior to EMH based strategy like buy-and-hold. Second, the market is becoming more and more efficient. ¡®In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.¡¯ (Investor Home n.d.) There are some predict patterns appear to help investors to beat...

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Fama, E. F. and French, K. R., 1992. The Cross-Section of Expected Stock Returns. Journal of Finance, XLVII (2), 427-465..
Fama, E. F. and French, K. R., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18 (3), 25-46.
Haugen, R. A, 2002. The Inefficient Stock Market: What Pays Off and Why. 2nd ed. New Jersey: Prentice Hall.
Haugen, R. A. and Lakonishok, J., 1988. The Incredible January Effect. Homewood: Dow Jones-Irwin.
ANON., 2005. The Efficient Market Hypothesis. Investor Home [online]. Available at: [Accessed 01/12/2005].
Malkiel, B.G., 2003. The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives, 17(1), 59-82.
Malkiel, B.G., 2003. Passive Investment Strategy and Efficient Markets. European Financial Management, 9 (1), 1-10.
Perold. A. F., 2004. The Capital Asset Pricing Model. Journal of Economic Perspectives, 18(3), 3-24.
Statement, M., 1999. Behavioural Finance: Past Battles and Future Engagements. Financial Analysts Journal, November/December, 18-27.
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