Efficient Market Hypothesis

Topics: Stock market, Financial markets, Fundamental analysis Pages: 25 (9019 words) Published: February 14, 2012
The efficient markets hypothesis (EMH) is a dominant financial markets theory developed by Michael Jensen, a graduate of the University of Chicago and one of the creators of the efficient markets hypothesis, stated that, “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis” [Jensen, 1978, 96]. This paper analyzes whether it is possible to measure if markets are efficient in the strong form of EMH. A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, Eugene Fama’s (1970) influential survey article, “Efficient Capital Markets.” 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, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial information such as company earnings, asset values, etc., to help investors select “undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks with comparable risk.

The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.

Definition of the Efficient Markets Hypothesis
In 1970 Eugene Fama coined the term efficient markets hypothesis and introduced its three forms: weak, semi-strong, and strong. The efficient markets hypothesis states that, “prices fully reflect all available information” (Fama, 1991, 1575). The efficient markets hypothesis assumes information is fully reflected in prices, price changes are continuous, investors are rational profit-maximizers sharing the same investment goals, expectations, and holding period, and security prices follow a submartingale [Mandelbrot, 2004, 83-87]. A process is a martingale if the present value of future cash flows is the current stock price. In 1965 Paul Samuelson proclaimed that the stock market is one such process. Fama further specified that security prices follow a submartingale, a type of martingale with positive expected returns instead of zero. The submartingale condition assumes stock prices always equal the present value of future cash flows (also known as intrinsic value), are normally distributed, and are independent of one another [LeRoy, 1989, 1585-1595 & Mandelbrot, 2004, 87]. Jensen also defines an efficient market as one in which prices reflect information to the point where marginal benefits of acting on information do not exceed the marginal costs(Jensen,1978).

Evidence in favour of market efficiency has examined the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behaviour of stock prices, and the success of technical analysis. Performance of Investment Analysts and Mutual...

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