Question

Describe the Theory of Efficient Markets. What is the primary notion of the Theory of Efficient Markets?

Answer 1

Efficient Market Hypothesis accords supremacy to market forces. A market is treated as efficient when all

known information is immediately discounted by all investors and reflected in share prices. In such a situation, the only price changes that occur are those resulting from new information. Since new information is generated on a random basis, the subsequent price changes also happen on a random basis. Major requirements for an efficient securities market are:

– Prices must be efficient so that new inventions and better products will cause a firms’ securities prices

to rise and motivate investors to buy the stocks.

– Information must be discussed freely and quickly across the nations so that all investors can react to the new information.

– Transaction costs such as brokerage on sale and purchase of securities are ignored.

– Taxes are assumed to have no noticeable effect on investment policy.

– Every investor has similar access to investible funds at the same terms and conditions.

– Investors are rational and make investments in the securities providing maximum yield.

Research studies devoted to test the random walk theory on Efficient Capital Market Hypothesis (ECMH) are put into three categories i.e.

(a) the strong form,

(b) the semi-strong form, and

(c) the weak form theory.