Question

Question 5.

(a) Briefly explain the basis for the Efficient Market Hypothesis (EMH)?

(b) Outline the tests for the three forms in which the EMH is commonly stated? Give examples of how these tests may be carried out?

(c) State three (3) limitations of the EMH?

Answer 1

(a) Efficient Market Hypothesis (EMH) defines that prices of asset contain full information. It means that market price must only react to new information and its impossible to beat the market on the basis of risk adjustment. This concept is a part of financial economics and was developed by "Eugene Fama" who proposed that assets are always traded at fair value, and it is not possible to purchase undervalued stocks or sell inflated priced assets by investors. Therefore investors can only gain on such assets is by chance or purchasing more riskier investments.

(b) Tests for the three forms in which EMH is commonly stated are - "weak", "semi-strong", and "strong" form efficiency.

• Weak form efficiency - in this variant, future prices cannot be predicted by analyzing the prices of the past. This could be tested on National equity market indices, stocks that have performed poorly over past 3-12 monthly will continue to perform poorly in the future 3-12 months.
• Semi-strong efficiency - In this variant, it is implied that share prices adjust themselves to available new information to the public very rapidly and in an unbiased manner, such that no extra profits can be made by trading on that information. To test this, the changes to previously unknown news must be of a fair amount and must be instantaneous.
• Strong Efficiency - in this variant, share prices reflect all information (public & private) such that no trader could earn excess profits. To test for strong-form efficiency, a market needs to prevail where investors cannot frequently earn extra returns over a long period of time.

(c) Limitations of EMH are -

1. EMH implications have failed in real life, as many economist have stated that financial crises of 2008 would not have occoured if principles of EMH were true.
2. EMH has failed to explian market volatality and speculative bubble.
3. Investment decisions nowadays are tend to be influened by emotions rather than rationality, because there are multiple sources of information nowadays.