Forms of EMH

Strongly efficient market

All information is reflected on prices.

Semi Strong efficient market All public

information is

reflected on security prices.

Weakly efficient

market All
historical

information is reflected on security prices.

 H
The week form of market holds that

present stock market prices reflect all known information with respect to past
stock prices, trends, and volumes.

This form of theory is just the opposite of the technical analysis because according to it, the
sequence of prices occurring historically does not have any value for predicting the future
stocks prices. The technical analysts rely completely on charts and past behavior of prices of
stocks.
 H
In the week form of the market no investor can use any information of the past to
earn a return of portfolio which is in excess of the portfolios risk.

This means that the investor who develops the strategy based on past prices and chooses
his portfolio on that basis cannot continuously outperform another investor who buys and
holds his investments over a long term period.
 H
Weak form takes only the average change of todays prices and states that they are
independent of all prior prices.
The evidence supporting the random walk behavior also supports the EMH and states that the
large price changes are followed by larger price changes, but they do not change in
any direction which can be predicated. This observation in a way violates the random walk
behavior that it does not violate the weak form of the market efficiency.
Researchers have studied that the evidence which supports the efficient market behavior is
based on the random walk behavior of security prices but there is evidence which
contradicts the random walk hypothesis. This does not mean that it contradicts the efficient
market hypothesis also.
 H
Three types of tests have been

commonly employed to empirically verify the weak- form efficient market hypothesis:

Serial correlation tests;

b Runs tests
c Filter rules tests.
Weak Form of EMH Serial Correlation
Test:

Serial Correlation is said to measure the association of a series of numbers which are
separated by some constant time period. One way to test for randomness in stock price
changes is to look at their serial correlations. Is the price change in one period correlated
with the price change in some other period? If such auto-correlations are negligible, the
price changes are considered to be serially independent. Numerous serial correlation
studies, employing different stocks, different time-lags, and different time-periods, have
been conducted to detect serial correlations. In general, these studies have failed to
discover any significant serial correlations.
Serial Correlation Test

Moore measured correlation of the price change of one week with the price change of the
next week. His research showed average serial correlation of -0.06 which indicated a very low
tendency of security price to reverse dates. This means that a price rise did not show the
tendency to follow the price fall or vice versa.
Fama also tested the serial correlation of daily price changes in 1965. He studied the
correlation for 30 firms which composed of the Dow Jones Industrial Averages for five years
before 1962. His study showed an average correlation of -0.03. This correlation was also
weak because it was not very far away from zero.
Weak Form of EMH Run Tes

t
Run Test was also made by Fama to find out it price changes were likely to be followed by
further price changes of the same sign. Run Test ignored the absolute values of numbers in
the series and took into the research only the positive and negative signs. Given a series of
stock price changes, each price (+) if it represents an increase or a minus (-) if it represents
a decrease. Run test is used to find out whether the series of prices movement have
occurred by chance. A run is uninterrupted sequence of the same observation.

cont..
Weak Form of EMH Run Tes

t
For Example: If a coin is tossed the following sequence my occur:
HHTTTHHHTHH
Here occurrence of HH is a run and TT is another run. When the sequence of the
observations change we count it as a run
Run Test Z = R X R = No. of runs X = 2n1
n2 +1
n1 + n2

2 = 2n1 n2 (2n1 n2 - n1 - n2 )

(n1 + n2 )2 (n1 + n2 -1)

n1 + n2 = No. of observations in each category Z = standard normal

variate
Weak Form of EMH Run Tes

t
Ques: Reliance Petroleum stock prices are given below , apply run test.

Run Run Run

Dat e Pric e Dat e Pric e Dat e Pric e

Sept. 7 52.15 27 56.80

20 43.05 8 52.50 28 53.50

21 43.40 11 53.45 29 51.50
22 41.75 12 57.55 Nov. 48.40
23 42.65 13 57.45 1 52.30
24 43.60 14 55.90 2 56.05
28 43.05 15 54.15 3 55.15
29 43.40 19 54.70 4 56.40
Oct. 1 46.80 20 58.95 5 57.15
4 46.60 21 60.30 7 57.25
5 47.50 25 59.65 9 57.55
4/2 0/1
17
5 47.40 26 58.65 10 56.75
Weak Form of EMH Filter rul

It is a technique for filtering out the important information from the unimportant.
e
Alexander and Fama and Blume took the idea that price and volume data are supposed to
tell the entire story we need to know to identify the important action in stock prices. They
applied filter rules to see how well price changes pick up both trends and reverses which
chartists claim their charts do.
If a stock moves up X%, buy it and hold it long; if it then reverses itself by the same
percentage, sell it and take a short position in it. When the stock reverses itself again by X%
cover the short position and buy the stock long. The size of the filter varied from 0.5 to 50%.
Weak Form of EMH Filter Rul

e
Example: Let filter in XY Ltd is 10%. The Price fluctuate between Rs. 20 to 30. Let starting
point to be 20. When there is an increase in the price to Rs. 22 i.e. 10% rise, one has to
buy it. The rally may continue upto Rs. 30 and decline. If the price falls the sell signal is
given at 27 Rs.

i.e. 10% of Rs. 30 and the trader can take up the short position till it reaches its low
level. When there is a rise in price the same exercises have to be followed.
The semi strong form of the EMH centers on how

rapidly and efficiently market prices adjust to new publicly available information. In this state,
the market reflects even those forms of information which may be concerning the
announcement of a firms most recent earnings forecast and adjustments which will have
taken place in the prices of security.

The investor in the semi-strong form of the market will find it impossible to earn a return on the
portfolio which is based on the publicly available information in excess of the return which may be
said to be commensurate with the portfolio risk.
 Many empirical studies have been made

on the semi-strong form of the efficient market hypothesis to study the reaction of security
prices to various types of information around the announcement time of the information.

Two studies commonly employed to test semi-strong form efficient market are:

Event study
Portfolio study.
 Event Study: It examines the market reactions

to and the excess market returns around a specific information event like acquisition
announcement or stock split. The key steps involved in an event study are as follows:

1 Identify the event to be studied and pinpoint the date on which the event was
announced.
2 Collect returns data around the announcement date. In this context two issues have to be
resolved: What should be the period for calculating returns weekly, daily, or some other
interval? For how many periods should returns be calculated before and after the
announcement date? Cont
 Event Study Cont

3

Calculate the excess returns, by period, around the announcement date for each firm in the
sample. The excess return is calculated by making adjustment for market performance and
risk.
4 Compute the average and the standard error of excess returns across all firms Assess
whether the excess returns around the announcement date are different from zero.

5 To determine whether the excess returns around the announcement date are different from

zero, estimate the T statistic for each day.

 Semi Strong Form of EMH

Portfolio study: In a portfolio study, a portfolio of stocks having the observable

characteristic (low price earnings ratio or whatever) is created and tracked over time see
whether it earns superior risk-adjusted returns. Steps involved in a portfolio study are as
follows:

1 Define the variable (characteristic) on which firms will be classified. The proposed investment
strategy spells out the relevant variable. The variable must be observable, but not
necessarily numerical. Cont..

2 Classify firms into portfolios based upon the magnitude of
the variable.

3 Collect data on the variable for every firm in the defined universe at the beginning of the
period and use that information for classifying firms into different portfolios.
4 Compute the returns for each portfolio on the returns for each firm in each portfolio for the
testing period and calculate the return for each portfolio, assuming that the stocks included
in the portfolio are equally weighted.
5 Calculate the excess returns for each portfolio. The calculation of excess returns earned by a
portfolio calls for estimating the portfolio beta and determining the excess returns.
Cont..

6 Assess whether the average excess returns are
different across the portfolios. Several statistical tests are available to test whether the
average excess returns differ across these portfolios.

Some of these tests are parametric and some nonparametric. Many portfolio studies
suggest that it is not possible to earn superior risk adjusted returns by trading on some
observable characteristics. However, several portfolio studies have documented
inefficiencies and

anomalies.
 H
This market hypothesis holds that all available

information, public or private, is reflected in the stock prices. The strong form is concerned
with whether or not certain individuals or groups of individuals possess inside information
which can be used to make above average profits. If the strong form of the efficient capital
market hypothesis holds, then and day is as good as any other day to buy any stock. This
the most extreme form of the EMH. Most of the research work has indicated that the
efficient market hypothesis in the strongest form does not hold good.
 H
Empirical Evidence: Many of the tests of the strong form of EMH deal with mutual fund

performances.

Financial analysts have studied the risk adjusted rates

of return from hundreds of mutual funds and found that the professionally managed funds
are not able to out perform the buy hold strategy.
Jensen had studied 115 funds over a decade. He concluded that even though the analysts
are well endowed with wide ranging contacts and associations in both the business and
financial committees, they are unable to forecast returns accurately enough to recover the
research and transaction costs. He holds this, as a striking piece of evidence for the strong
form of EMH
 ies
Anomalies are situations that appear to violate the

traditional view of market efficiency, suggesting that it may be possible for careful investors
to earn abnormal returns. Some stock market anomalies are:

1 Low Price-Earnings Ratio: Stock that are selling at price earnings ratios that are low relative
to the market.
2 Low Price-Sales Ratio: Stocks that have price-to- sales ratios that are lower competed with
other stocks in the same industry or with the overall market.
3 Low Price-to Book value Ratio: Stocks whose stock prices are less that their respective book
values.

Cont
 ies
4 High Dividend Yield: Stocks that pay high dividends
relative to their respective share prices.

5 Small companies: Stock of companies whose market capitalization is less than

100 million.
6 Neglected Stocks: Stocks followed by only a few analysts and/or stocks with low
percentages of institutional ownership.
7 Stocks with High Relative Strength: Stocks whose prices have risen faster relative to the
overall market.
8 January Effect: Stock do better during January than during any other month of the year.
9 Day of the Week: Stock of poorer during Monday than during other days of the week.
Market Efficiency: The expectations of the investors
regarding the future cash flows are translated or reflected on
the share prices. The accuracy and the quickness in which the
market translates the expectation into prices are termed as
market efficiency. These are of two types:

(1) Operational Efficiency: It can be measured by

factors like time taken to execute an order and the
number of bad deliveries. Investor are concerned
with this type of efficiency but EMH does not.
(2) Informational Efficiency: It is a measure of the
swiftness or the markets reaction to new
information like
economic reports, company analysis, political
statements & new industrial policies.

Liquidity Traders: These traders investments and resale

of shares depends upon their individual fortune. Liquidity

traders sell their shares to pay their bills. They dont
investigate before they invest.

Information Traders: These investors analyze before

any buy or sell. They estimate the intrinsic value of

shares. The deviation between the intrinsic value and
the market value makes them enter the market. They
sell if the market is higher than the intrinsic value and
vice-versa. The buying and selling of the shares through
the demand and supply forces bring the market price
back to its intrinsic value.
 Random-Walk Theory

An efficient market is one in which the market price of a

security is an unbiased estimate of its intrinsic value.

Note: Market efficiency does not imply that the

market price equals intrinsic value at every point in time.

All that it says is that the errors in the market prices are
unbiased. This means that the price can deviate from the
intrinsic value but the deviations are random and
correlated with any observable variable. If the deviations
of market price from intrinsic value are random, it is not
possible to consistently identify over or under-valued
securities.

No Bargain

Market efficiency is defined in relation to information

that is reflected in security prices. In an efficient market,
all the relevant information is reflected in the current
stock price.
Information cannot be used to obtain excess return. The
information has already been taken into account and
absorbed in the prices.
In other words, all prices are correctly stated and there are
no bargains in the stock market.

Requirements for efficient

market

1. Prices must be efficient so that new inventions and

better products will cause a firms securities prices
to rise and motivate investors to supply capital to
the firm (i.e., buy its stock).
2. Information must be discussed freely and quickly
across the nations so all investors can react to new
information.
3. Transactions costs such as sales commissions on
securities are ignored.
4. Taxes are assumed to have no noticeable
effect on investment policy.
5. Every investor is allowed to borrow or lend at the same
rate.
6. Investors must be rational and able to recognize
efficient assets and that they will want to invest money
where it is needed most (i.e., in the assets with
relatively high returns).
Basic Concepts
1.Market efficiency
: the accuracy & quicknessin which the market translates theexpectation into the
prices are termed asmarket efficiency. There are two types of market
efficiency :ii.Operational efficiencyiii.Information efficiency

2.
Liquidity traders
: these tradersinvestments & resale of shares depend upontheir individual fortune.
They do notinvestigate before they invest

3. Information Traders
: they analyze beforeadopting any buy or sell strategy. Theyestimate intrinsic value of
share.

Efficient Market

AccordingE.F.Fama Efficient market isdefined as the market where there arelarge number of
rational profit-maximisers,actively competing with each other topredict even the
market value of individualsecurities and where current information isalmost freely
available to all participants.

Features of Efficient Market

All instruments are correctly priced as allavailable information is perfectlyunderstood

and absorbed by all theinvestors.

No excess profits are possible.

In a perfectly efficient market analystsimmediately compete away any chance

of earning abnormal profits.

The forces of demand and supply movefreely and in an independent and
randommanner.

Explanation for the efficiencyof the markets

The equilibrium price of the security isdetermined by demand and supply

forcesbased in available information. Thisequilibrium price will immediately changeas
fresh information becomes available.
Assumptions

Information must be free and quick to flow.

There are no transaction costs and bottlenecks.

Taxes donot impactinvestmentpolicy.

Every investor can borrow or lend at the samerate.

Investors behave rationally.

Market prices are efficient and absorb themarket information quickly and efficiently.

Future price changes will be due to newinformation not available earlier.

FORMS OF THE EFFICIENTMARKET HYPOTHESIS (EMH)
Efficient market hypothesis can be divided intothree categories:1. The weak
form2. The semi strong form, and3. The strong form

Weak form of EMH

:
according to it , currentprices reflect all information which isalready contained in
the past. The weakform of theory is just opposite of technical analysis. In the weak
form of efficiency market, the past prices do notprovide help in giving any
informationabout the future prices. The short termtrader adopt buy & hold strategy
.
2.Semi Strong Form
: The semi strongform of the efficient markethypothesis says that current prices
of stocks reflect all publicly availableinformation. In effect, the semi strongform of
the efficient markethypothesis maintains that as soon asinformation becomes
publiclyavailable, it is absorbed and reflectedin stock prices. Even if this adjustment
Strong Form of EMH
: Strong form of theefficient market hypothesis maintains thatsecurity prices fully reflect
all information,including both public and private information.Specifically, no
information that is available beit public or insider can be used to consistentlyearn
superior investment returns. This impliesthat not even security analysts and
portfoliomanagers who have access to informationmore quickly than the general
investing publicis able to use this information earn superiorreturns.
Empirical Tests of weak form
1.Empirical test on weak form
:ii.SimulationTestsiii.Serial correlation testsiv.RunTestsv.FilterTestsvi.Distribution Patterns

2. Empirical Tests of Semi-Strong form :

i.Market Reaction test.ii.AnnouncementTest

3.
Empirical test of the strong from :
i.Mutual fund performance
Random Walk -Conclusions

It suggests that the successive pricechanges are independent. & thesesuccessive

price changes are randomlydistributed. This model argues that allpublicly available
information is fullyreflected on the stock prices & further thestock prices
instantaneously adjustthemselves to the available information.
technical and fundamentalanalysis

Random walk and technical analysis :

The random walk theory is inconsistent withtechnical analysis.

Random walk states that successive pricechanges are independent, while the
technicalanalysts claim that the historical price behaviorof the stock will repeat itself
into the future andthat by studying this past behavior the chartistcan predict the
future.

Random walk and Fundamental Analysis

The random walk hypothesis is entirelyconsistent with an upward or

downwardmovement in price.

The hypothesis supports fundamentalanalysis and certainly does not attack it.

Random walk implies that short run pricechanges are random about the intrinsic
value of the security and are independent of each other.
SWOT Analysis

Strength

Weaknesses

Opportunities

Threat

Competitive Structure of Industry

1)Rivalry among existing firms2) Threat of new entrance3) Threat of
substitutes4)Bargaining power of suppliers5)Bargaining power of buyers