The Efficient Market Hypothesis

In an efficient market all the known informationis immediately discounted by all the investors and reflected in the security prices in the market.

According to James Loire:

“Efficiency means the ability of the capital market to function, so that prices of securities react rapidly to new information. Such efficiency will produce prices that are appropriate in terms of current knowledge and investors will less likely to make unwise investments.”

Meaning

Information must be free and quick to flow. Bottlenecks and cost are not there. Taxes have no noticeable impact. Every investors can borrow on lend at same rate. Investors are rational. Market prices are efficient and not sticky.

Assumptions

The Random Walk Hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted.

Random walk theory

Perfectly competitive market.

No individual investor or group can influence it.

All investors have same knowledge.

Stock market discount all the information quickly.

Institutional investors or major fund managers have to follow the

market.

The price moves in an independent fashion without undue presence.

Future changes in price will only be as a result of some other new

piece of information.

Assumptions

The Efficient Markets Hypothesis (EMH) is made up

of three forms:

◦ Weak Form

◦ Semi-strong Form

◦ Strong Form

The EMH Graphically

In this diagram, the circles represent the amount of information that each form of the EMH includes.

Note that the weak form covers the least amount of information, and the strong form covers all information.

Also note that each successive form includes the previous ones.

Strong Form

Semi-Strong

Weak Form

All information, public and private All public information

All historical prices and returns

This form of market holds that current prices of stocksfully reflect all historical information, thus past datacannot be used to predict future prices.

Tests of the Weak Form Serial correlations Runs tests Filter rules

The Weak Form

The semi strong form states that current prices instantaneously reflect all publicly available information such as quarterly reports, changes in accounting information, dividends, splits etc.

Test of Semi Strong Form

Market Reaction Test

Earning Impact

Secondary Offering Impact

Block Trade Impact

Bonus Impact

The Semi-strong Form

The strong form says that prices fully reflect all information, whether publicly available or not.

Even the knowledge of material, non-public information cannot be used to earn superior results.

Most studies have found that the markets are not efficient in this sense.

Test Of Strong Form Trading By Stock Exchange Officials. Trading By Mutual Fund Managers.

The Strong Form

Markets Have No Memory Trust Market Prices Read The Entrails There Are No Financial Illusions Do It Yourself Alternative Seen One Stock, Seen Them All

Six Lessons For Market Efficiency