Question

Explain the term ‘Efficient Market Hypothesis’. Analyse the various forms of Efficient Market Hypothesis showing how each of them can be tested. Use practical examples to demonstrate an understanding of any security trading strategies which may support or otherwise the claims of the Efficient Market Hypothesis.

Word count required: 400-450 words

Answer 1

Solution:

Efficient Market Hypothesis states that capital markets are efficient in processing information. Security prices equal their intrinsic values at all times and fully reflect all available information.

The underlying meaning is:

- New information is processed immediately as it arrives
- Prices instantaneously adjust to the new levels
- Investor cannot consistently earn excess returns by undertaking fundamental analysis or technical analysis.

Capital market is considered to be efficient in three different forms: Weak form; Semi-strong form; Strong form.

Division is based on assumptions of different type of information
Weak Form: Past sequence of security price movements
Semi-Strong Form: Publicly available information
Strong Form: All information, both public and private (or insider)

A] Weak form of EMH:

Current stock prices already fully reflect all the information that is contained in the historical sequence of prices. New price movements are completely random.
There is no benefit in studying historical sequence of prices to gain abnormal returns from trading in securities
Weak form of EMH is direct repudiation of Technical Analysis.

Serial Correlation Test to test weak form of EMH
- Correlation between price changes in one period and changes for the same stock in other period
- Test Result: No Correlation
Distribution Pattern to test weak form of EMH
- Distribution pattern of the price changes is compared with normal distribution or Brownian motion (motion of suspended particles)
- Test Result: Similarity in the patterns

Conclusion: The results of empirical studies have been virtually unanimous in finding little or no statistical dependence and price patterns and this has corroborated the weak form of EMH.

B] Semi-Strong form of EMH

Current stock prices not only fully reflect all the information that is contained in the historical sequence of prices, but also all publicly available information about the company.
Stock prices instantaneously adjust to the information that is received. So no time gap in which a fundamental analyst can trade for superior gains.
Semi-Strong form of EMH is direct repudiation of Fundamental Analysis

Residual Analysis Test
- For any event: Difference between expected return (using single index model) and actual return of the stock
- Test Result: All test suggested market is relatively efficient (some contradictory results)

Conclusion: Markets are relatively efficient.

C] Strong form of EMH:

Current stock prices reflect all the information both publicly available information as well as private or insider information.

This implies that no information, whether public or inside, can be used to earn superior returns consistently.

Insider Information Test
- Determine excess returns for individuals having insider information
- Test Results: Yes, individuals with insider information can make excess return

Mutual Funds and Analyst Test
- Capability of MFs to generate excess returns as against randomly constructed portfolios
- Test Results: No better performance by MFs

Conclusion: Markets are in-efficient in Strong Form.
- Insider information can be used to earn above average returns
- Mutual Funds and Analysts have not been able to earn superior returns using their private information

Weak form on EMH contradicts Technical Analysis. Semi-Strong form of EMH contradicts Fundamental Analysis. Strong form of EMH maintains that not only publicly available information is useless to the investor or analyst but all information is useless.

However, the market is efficient because of the organized and systematic efforts of thousands of analyst undertaking fundamental and technical analysis.

Paradox of EHM is that both fundamental and technical analysis is required to make the market efficient.

-x-