Question

The prices of stocks at any point should reflect, fully, all available information. We live in the internet era where information is readily available. Investors react to information and the price of stocks react accordingly. Write a paper about the forms of stock market efficiency and the tests of the efficient market hypothesis. Include in your discussion a comparison and contrast between the Christian worldview and the secular worldview about the stewardship of money. 500 words minimum

Answer 1

WHAT IS EFFICIENT MARKET HYPOTHESIS?

1. The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information.

2. The efficient-market hypothesis was developed by Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.

3. The efficient-market hypothesis states that financial markets incorporate relevant information very quickly.

4. Eugene Fama developed a framework of market efficiency that laid out three forms of efficiency:

• Weak form,
• Semi-strong form
• Strong form

5. Each form is defined with respect to the available information that is reflected in prices. Investors trading on available information that is not priced into the market would earn abnormal returns or excess risk-adjusted returns.

FORMS OF STOCK MARKET EFFICIENCY:

A. WEAK FORM EFFICIENCY (Also called as RANDOM WALK THEORY)

MEANING:

1. In the weak-form efficient market hypothesis, all historical prices of securities have already been reflected in the market prices of securities.

2. In other words, technicians – those trading on analysis of historical trading information – should earn no abnormal returns.

3. Research has shown that this is likely the case in developed markets, but less developed markets may still offer the opportunity to profit from technical analysis

DEFINITION:

Weak form efficiency is an investment analysis theory that states future stock prices cannot be readily estimated by past prices or historical values and trends.

EXAMPLE:

Peter is an investor who has recently developed an interest in investment trading. He is not so experienced, and he wants to collect historical data on the stocks he owns in order to earn an excess return. What should Peter do?

Peter observes that the price of a particular stock lost 7% on Tuesday and earned 5% on Thursday. So, Peter decides to purchase 100 shares of this stock for $10 per share. The stock continues to fluctuate, and Peter needs to compare the stock’s current performance with its past performance. Following the technical analysis patterns, he comes to no concrete conclusion. Is the market, perhaps weakly efficient?

The answer is yes. The market is weakly efficient because it does not allow Peter to earn an excess return by picking stocks based on their past performance and historical data.

B. SEMI-STRONG FORM EFFICIENCY (SSFE)

MEANING

1. The SSFE does not use historical prices, trading volume, rates of return, earnings, dividend payments, profitability ratios, stock splits or any other element of fundamental analysis.

2. The hypothesis assumes that investors, who trade their securities based on newly available information, should expect an average risk rate of return.

3. To outperform the market, investors should accept a higher level of risk.

DEFINITION

The semi-strong form efficiency is a type of efficient market hypothesis (EMH), which holds that security prices adjust quickly to newly available information, thus eliminating the use of fundamental or technical analysis to achieving a higher return.

EXAMPLE

Agatha buys 500 shares of a construction company that currently trade at $38 per share. A few days later, she reads in the financial news that the company is expected to release outstanding results in the third quarter due to a successful deal with a foreign company.

Once the construction company releases its third-quarter results, the stock price rises as expected. As a matter of fact, for a week, the stock price rises to $45 but then drops to $36. Agatha wonders why the price does not rise further.

Obviously, the market is semi-strong form efficient and adjusts quickly to the newly available information – in this case, the company’s strong results. To realize a profit, Agatha should sell some of her shares at $45 per share as soon as the market adjusted to the new information. Instead, Agatha held all her shares, thus losing money.

If Agatha had sold 200 shares at $45 per share, she would realize a gross gain of $9,000. Now that Agatha held all her 500 shares, she loses 500 x $45 – 500 x $36 = $22,500 – $18,000 = $4,500, i.e. the difference between the price she bought the shares and the price they trade.

C. STRONG FORM EFFICIENCY (ALSO CALLED AS PERFECT MARKET THEORY)

MEANING

1. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.

2. Therefore, insiders could not generate abnormal returns by trading on private information because it would already figure into market prices.

3. Researchers find that markets are generally not strong-form efficient as abnormal profits can be earned when nonpublic information is used.

EXAMPLE

Abhi works at SBE Automobiles as their chief engineer. He was working on a new advanced model of automobiles and the project was a big success. He was sure that this project will result in an increase in price so he purchased 10,000 shares of SBE Automobiles for $25 per share. He was surprised to see that even after the news of the project being a success spread, the share price did not increase.

The market seems to be strong form efficient because it had already adjusted SBE Automobiles' stock price for the expected net present value of the new project. It already reflected the inside information.

TESTS OF EFFICIENT MARKET HYPOTHESIS:

Weak form

A very direct test of the weak form of market efficiency is to test whether a time series of stock returns has zero autocorrelation. A simple way to detect autocorrelation is to plot the return on stock on day t against the return on day t+1 over a sufficiently long time period. The time series of returns will have zero autocorrelation if the scatter diagram shows no significant relationship between returns on two successive days.

Example:

- Consider the following scatter diagram of the return on the FTSE 100 index on London Stock Exchange for two successive days in the period from 2005-6.

As there is no significant relationship between the return on successive days, the evidence is supportive of the weak form of market efficiency.

Semi-strong form

A common way to test the semi-strong form is to look at how rapid security prices respond to news such as earnings announcements, takeover bids, etc. This is done by examining how releases of news affect abnormal returns.

One should expect the abnormal stock return to occur around the news release. Below figure illustrates the stock price reaction to a news event by plotting the abnormal return around the news release. Prior to the news release, the actual stock return is equal to the expected (thus zero abnormal return), whereas at day 0 when the new information is released the abnormal return is equal to 3 percent. The adjustment in the stock price is immediate. In the days following the release of information, there is no further drift in the stock price, either upward or downward.

Strong form

A simple test for strong form of market efficiency is based upon price changes close to an event. The strong form predicts that the release of private information should not move stock prices. For example, consider a merger between two firms. Normally, a merger or an acquisition is known about by an "inner circle" of lawyers and investment bankers and firm managers before the public release of the information. If these insiders trade on private information, we should see a pattern close to the one illustrated in figure below. Prior to the announcement of the merger a price, run-up occurs since insiders have an incentive to take advantage of the private information.

Although there is ample empirical evidence in support of the efficient market hypotheses, several anomalies have been discovered. These anomalies seem to contradict the efficient market hypothesis.