TABLE OF CONTENT

INTRODUCTION

LITERATURE REVIEW

FINDINGS

CONCLUSION

REFERENCES

DBA 7043

1.0 INTRODUCTION
We may wonder how financial mangers know whether he or she is maximizing
shareholder value and how ethical or unethical behaviour may affect the value of the
company. This information is provided daily to the financial mangers through the price
changes determined in the financial markets. Financial markets are the meeting place for
people, corporations and institutions that either need money or have money to lend or invest.
Financial market can be broken down into many distinct parts such as domestic, international,
corporate or government and others such as money and capital markets. Money market refers
to those markets dealing with short-term securities for a life span of one year or less. Capital
markets such as common stock, preferred stock and government bonds are those markets
where securities have a life of more than one year (Block, Hirt, & Danielsen, 2009).
Undoubtedly, that there is a remarkable interaction between financial market and financial
theories. However, financial theories are subjective and there is no proven law in finance but
rather provides ideas that try to explain how the market works. One of the theories that have
been the central proposition of finance till today is the Efficient Market Theory. It deals with
informational efficiency of the capital market and is one of the most thoroughly tested
hypotheses in finance.
2.0 LITERATURE REVIEW
Efficient Market Hypothesis (EMH) is a concept in which describes that the market is
efficient when it reflects all the relevant information about an individual stock and the stock
market as a whole (Malkiel, 2003). The study on EMH has started over the past four decades
using a variety of methodologies. However, this concept remains as unresolved empirical
issues as to whether the capital market satisfies the notion of market efficiency.
The evolution of the efficient market was said to be appeared back in 16th century
from various fields such as botany, physics, and logics as well (Swell, 2011). However, the
EMH was first expressed by a French Mathematician named Louis Bachelier in 1900 in his
PhD dissertation entitled The Theory of Speculation (Swell, 2011) where he argued that the
expected return of an investment is always equals to zero. In other words, it was speculated
that the movement of stock prices follows a Brownian motion which is known as a random
movement (Degustis & Novickyte, 2014). This idea was later picked up Maurice G. Kendall
2

DBA 7043
a statistician in 1953 where he presented his documents that the prices of stock and
commodity seem to follow a random walk (Swell, 2011). In economics terms, the concept of
EMH was first discovered at the end of 19th century by George Gibson (Degustis &
Novickyte, 2014; Swell, 2011). The concept was clearly mentioned in his book entitled The
Stock Market of London, Paris and New York (Swell, 2011). He argued that the stock prices
reflect the views of the smartest participants (Degustis & Novickyte, 2014; Swell, 2011). The
studies on EMH was continued by many researchers, nonetheless the contribution and
research work became prominent and classic in year 1965 by Eugene F. Fama who earned a
PhD in finance (Degustis & Novickyte, 2014). He defined the EMH for the first time and
made a conclusion that the stock market prices follow a random walk (Swell, 2011). He then
undertook the first event study and published a definitive paper on the efficient market
hypothesis entitled Efficient Capital Market: A review of theory and empirical work in year
1970. He focused on the comprehensive review of the theory and the empirical work thus
confirmed the randomness of stock price (Swell, 2011; Degustis & Novickyte, 2014).
According to Fama, EMH is defined as A market in which prices always fully reflect
available information is called efficient. (Kadir, 2010; Degustis & Novickyte, 2014). Fama
also further expanded from H.Roberts model (1967) on the concept of EMH that made a
distinction between weak and strong form of market efficiency (Swell, 2011; Degustis &
Novickyte, 2014). Fama used this as basic taxonomy and added the semi strong form of
market efficiency in 1970 (Kadir, 2010; Swell, 2011; Degustis & Novickyte, 2014).

3.0 FINDINGS
As per Fama concept, the EMH is divided into three main stages known as weak,
semi-strong and strong market efficiency (Swell, 2011; Kadir, 2012; Degustis & Novickyte,
2014). The weak form of market efficiency states that all information contained in past price
movements is fully reflected in current market price. This hypothesis assumes that the rates of
return in market should be independent where the past price information is unrelated to future
prices and that trend is not able to be predicted and taken advantage by the investors (Bodie
et al., 2001; Block et al., 2009). This version of hypothesis implies that the trend analysis is
fruitless. The semi-strong hypothesis states that stock adjust quickly to absorb new
information whereby the current market prices reflect all publically available information.
This includes information such as fundamental data on the firm product line, addition to past
prices, quality of management, balance sheet composition, patents held, earning forecast and
3

DBA 7043
accounts practices (Bodie et al., 2001). Most of the research in this area focuses on changes
in public information and on the measurement of how rapidly prices coverage a new
equilibrium after a new information has been released (Bodie et al., 2001; Block et al., 2009).
The final stage is the strong form which states that the current market process reflects all
pertinent information whether publically available or inside information privately held. This
form of hypothesis implies that market is efficient.

Figure 3.0 : Three forms of Efficient Market Hypothesis

by Eugene F. Fame (1970)
Many empirical studies have been conducted to test the validity of the three forms of
market efficiency. Most empirical studies are joint test of the EMH and a particular asset
pricing model such as the Capital Asset Pricing Model (CAPM) (Bodie et al., 2001; Block et
al., 2009; Brigham et al., 2011; Balling & Gnan, 2013). They are joint test in the sense that
they examine whether a particular strategy can beat the market, where beating the market
means getting a return higher than that predicted by the particular asset pricing model.
Generally researches have indicated that markets are somewhat highly efficient in the weak
form and reasonably efficient in semi-strong sense, at least for the larger and more widely
followed stocks. The evidence suggests that the strong form of EMH does not hold because
private and insider information may be valuable but it is illegal to use for quick profits
((Bodie et al., 2001). However, some may argue that the corporate should have access to the
pertinent information for them to profit from the trading before it is release to public.
4

DBA 7043
Regardless, the Securities and Exchange Commission (SEC) has enforces an act, Security
Exchange Act of 1934 to regulate the securities markets and those companies listed on the
exchanges to prevent insiders from profiting and exploiting the privileged situation (Bodie et
al., 2001). Researches tend to support the weak form of EMH which causes many other
researches to question the overall value of technical analysis. This suggests that technical
analysis and charts would not be useful to predict the future price movements. Technical
analysis is the use of past price movements to predict the price fluctuations. The semi-strong
is also reasonably supported by researchers and this form would tend to question the value of
fundamental analysis by the individual investor. There are some contradictions to the semistrong form and much research is aimed at providing additional data.
In addition a number of contradictions have arises whereby researches have also
begun in incorporate elements of cognitive psychology in an effort to better understand how
individuals and entire markets respond to different circumstances (Degustis & Novickyte,
2014; Brigham et al., 2011). For an instance, if people are not rational in their daily decisions,
why we should expect them to be rational in their financial decisions? We have to keep in
mind that EMH does not assume that all investors are rational. Instead it assumes that stock
market prices reflects intrinsic values whereby a new information should cause a stocks
current value to move to a new intrinsic value based on that new information. It also further
assumed that whenever stock prices deviates from a their intrinsic values due to a lag in
incorporation of new information, investors will quickly take advantage of mispricing by
buying undervalued stock and selling overvalued stock. Therefore, it is possible to have
irrational investors in a rational market ((Degustis & Novickyte, 2014; Brigham et al., 2011).
On the other hand, if the market itself is irrational, then rational investors can lose a lot of
money even if they are ultimately proven to be correct.
The first implication of EMH for financial decision is that many investors have given
up trying to beat the market because the professionals who manage mutual fund portfolios on
average do not outperform the overall stock market measured by an index. Indeed, the
relatively poor performance of actively managed mutual funds helps to explain the growing
popularity of indexed funds where the administrative cost is relatively low (Brigham et al.,
2011). The second implication is where EMH also has important implications for managerial
decisions, especially stock issues, stock repurchases, and tender offers. If the market stock
prices stocks fairly, the managerial decision is based on the premise that a stock is
5

DBA 7043
undervalued or overvalued might not make sense. Managers may have better information
about their own companies than outsiders but they are not supposed to use this information
for their own advantage as it can be deliberately defraud any investors (Brigham et al., 2011).

4.0 CONCLUSION
The introduction of the Efficient Market Hypothesis has provided an analytical
framework for understanding the asset prices and also an explosion of research of their
behaviour. An important debate among stock investors is whether the market is efficient. For
an instance when money is invested in the stock market, the goal is to generate a return on the
invested capital. Many investors not only intend to make a profitable return but also
outperform the market. However, given all the theoretical and empirical evidence for and
against EMH, there is still no consensus among researches and the discernment of the
investment pattern. Therefore one must specify additional structure in terms of investors
preference and information structures to obtain an optimal result.

REFERENCES
Block, Hirt and Danielsen. (2009). Foundation of Financial Management, pp 455-456
6

DBA 7043
Bodie, Kane and Marcus. (2001). Market Effiiency. MacGrew Hill, pp 349-385
Brigham, Ehrhardt, Gessaroli and Nason. (2011). Financial Management Theory and
Practice, pp 300-304
Degustis, A. And Novickyte, L. (2014). The Efficient Market Hypothesis: A Critical Review
of Literature and Methodology. Journal of Economics, Vol 93 (2)
Kadir, C.Y. (2010). Market Rationality: Efficient Markey Hypothesis versus Market
Anomalies. European Journal of Economics and Political Studies, Vol 3(2)
Malkiel,B,G, (2003). The Efficient Market Hypothesis and its Critics. Journal of Economics
Perspectives, Vol 17(1), pp 59-82