Critical Analysis of Efficiency Market Hypothesis

Topics: Stock market, Fundamental analysis, Technical analysis Pages: 8 (2604 words) Published: October 20, 2013
ABSTRACT Michael Jensen writes, “There is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.” The term ‘Efficient Market Hypothesis’ (EMH) is concerned with the behavior of prices in asset markets. It was initially applied to the stock market, but the concept was soon generalized to other asset markets. EMH has also been a subject of debate since its inception in the 1960s. INTRODUCTION

This essay critically discusses’ A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions.’(With respect to Technical & Fundamental Analysis).

In this essay, firstly, the Efficient Market Hypothesis (EMH) is given an appraisal in relation to random walk, as well as its definition, revealing theories in context of empirical evidence. A brief explanation of the 3 forms of EMH is highlighted alongside a brief description of its tests for validity. The main focus of discussion is whether or not Technical & Fundamental Analysis can determine abnormal returns by investors strategically using a set of information to formulate buying and selling decisions to beat the efficient market. (Graphs and sets of equations may be applied). Following general empirical studies, the theory of Efficient Market typically asserts that, it would be impossible to consistently outperform the market by means of technical & fundamental analysis, consequently, in the light of this assertion, technical, fundamental and other anomalies are revealed that may suggest some levels of market inefficiencies. Finally, a conclusion, subjectively underlining the relevant points expressed above, putting to perspective facts conveyed through the topic of critical discussion.

Appraisal of the Efficient Market Hypothesis and Random Walk The efficient market hypothesis is a financial theory widely accepted by most academic financial economists. It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, when the term ‘efficient market’ was introduced into the economics literature in the 1960s , it was defined as a market in which prices at any time “fully reflect” and ‘adjusts rapidly to new available information’ (Eugene F. Fama, 1970, p 383.). In the context of this hypothesis, “efficient” empirically, means that the market is capable of quickly digesting new information on the economy, an industry, or the value of an enterprise and accurately impounding it into securities prices. In such markets, participants can expect to earn no more, nor less, than a fair return for the risks undertaken, hence failing to provide abnormal returns. Random Walk, is a Theory closely associated with the efficient market hypothesis, was originally created by Louis Bachelier (1900), and developed by Kendall, in 1950s. Kendall (1953) found that stock and commodity prices follow a random walk. Random walk varies with regard to the time parameter. According to capital markets theory, the expected return from a security is primarily a function of its risk. The price of the security reflects the present value of its expected future cash flows, which incorporates many factors such as volatility, liquidity, and risk of bankruptcy. However, while prices are rationally based, changes in prices are expected to be random and unpredictable, because new information, by its very nature, is unpredictable. Therefore stock prices are said to...

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