Question 1: Examine the relevance of the Efficiency Market Hypothesis for a financial manager

Efficiency Market Hypothesis

Capital Market can be defined as an institutional arrangement which facilitates lending and borrowing of
long term funds. An efficient capital market is one which mobilizes the public savings, makes available
finance to those who are in need of it at a reasonable rate and promotes the efficiency and growth of
economy. It facilitates the long term funds to the industrial and commercial enterprises which want to
make investments in new capital issues and cater to the needs of the wide range of people which leads to
the social and economic development of a country, Gupta, Shashi K. and Joshi, Rosy. “Security
Analysis and Portfolio Management”, 2010. Efficiency refers to the ability of the capital market to act in
such a manner that the security prices reflect current/new information in an unbiased manner and the
prices are determined on the basis of demand and supply. In an efficient market, the information flows
with an ease and all the known informations are encashed by the investors and the same is reflected in
the security prices in an unbiased manner.

The efficient and effective operation of financial markets, particularly capital markets, constitutes the
foundation of the development of the modern economy. The stock markets play a crucial role in capital
allocation and its transformation from savings to financing new investment initiatives, consequently
creating more wealth. The financial investments on capital markets refer to the flow of all streams of
funds managed by banks and financial institutions, mainly the stock exchange and institutions investing
in it, i.e. investment funds, pension funds and insurance companies. The main objective of stock markets
is to provide capital inflow for entities issuing stocks, thereby allowing them to grow and to create
wealth for investors, who invest their free capital in stocks, which they perceive as attractive
investments.

Stock market is a central role in the relevant economy that mobiles and allocates financial recourses and
play a crucial role in pricing and allocation of capital. Stock market provides the required fund for
establishing, or expansion businesses, it further encourages people to open a new channel of savings into
business investment. If share prices are reflected all accurate and available information of the relevant
firms, which firms will be able to make a profit or the right production, and investors are able to invest
in the most appreciate firm. Therefore, the market can be considered as an efficient market. If stock
price do not fully reflect all information, then the opportunity of gain abnormal return is existence by

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collecting information. Moreover, Stock price and return under the Efficiency Market Hypothesis act as
benchmarks for the cost of capital and returns on the investment projects, Green at al. 2000.

The "market efficiency" term is used to explain the relationship between information and the stock price
in the capital market literature. It examines the degree of the available information which incorporated
into stock prices. The market efficiency is an important concept to financial managers in terms of an
understanding of the mechanism of stock markets and also understanding their performance and
contribution of the development in the relevant economy. This importance is due to net present value
investment criterion, timing of financing decisions, and mergers and acquisition as these assume
existence of efficient markets" study by Kanukuntla and Rao, 2003, Moustafa, 2004. If the stock market
is efficient that the price will reflect the true values of the stock, then, the scarce saving will be
efficiently allocated to productive investment and this investment will be benefit for both individual
investors and the country’s economy, Copeland and Weston, 1988: Moustafa, 2004.

Implications of EMH for financial managers, if the markets are quite strongly efficient, the implications
for the financial managers are:

1. Concentrate on maximizing the net present value of the company’s investments in order to
maximise the wealth of shareholders.
2. There is no worry about how past actions/investments and current performance will affect the
share price.
3. There is no attempts to strategies that will mislead the market, such as the timing of new shares
issuance, window dress the accounts, change the market’s view regarding the company’s cost of
capital.

Relevance of Efficiency Market Hypothesis.

If the markets are quite strongly efficient, the main consequence for financial managers will be that they
simply need to concentrate on maximizing the NPV of the company’s investments in order to maximize
the wealth of shareholders. Managers need not worry, for example, about the effect on share prices of
financial results in the published accounts because investors will make allowances for low profits or
dividends in the current year if higher profits or dividends are expected in the future.

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If the company is looking to expand, the directors will be wasting their time if they seek as takeover
targets companies whose shares are undervalued, since the market will fairly value all companies’
shares. Only if the market is semi-strongly efficient, and the financial managers possess inside
information that would significantly alter the price of the company’s shares if released to the market,
could they perhaps gain an advantage. However, attempts to take account of this inside information may
breach insider dealing laws.

1. The Timing Of Financial Policy

Some financial managers argue that there is a right or wrong time to issue securities i.e. new shares
should only be issued when the market is at the top rather than the bottom. If the market is efficient,
however, price follows a trendless random walk and its impossible for managers to know whether
today’s price is the highest or the lowest. Timing other policies e.g. release of financial statements,
announcement of stock splits, etc has no effect on share prices.

2. Project Evaluation Based Upon NPV

When evaluating new projects, financial managers use the required rate of return drawn from securities
traded in the capital market. For example, the rate of return required on a particular project may be
determined by observing the rate of return required by shareholders of firms investing in projects of
similar risk. This assumes that securities are fairly priced for the risks that they carry i.e. the market is
efficient). If the market is inefficient, however, financial managers could be appraising projects on a
wrong basis and therefore making bad investment decisions since their estimate on NPV is unreliable.

3. Creative Accounting
In an efficient market, prices are based upon expected future cash flow and therefore they reflect all
current information. There is no point therefore in firms attempting to distort current information to
their advantage since investors will quickly see through such attempts. Studies have been done for
example to show that changes from straight-line depreciation to reducing balance method, although it
may result to increasing profit, may have no long-term effect on share prices. This is because the
company’s cash flows remain the same. Other studies support the conclusion that investors cannot be
fooled by manipulation of accounting profit figure or charges in capital structure of company.
Eventually, the investors will know the cash flow consequences and alter the share prices
consequently.

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 4. Mergers and Takeovers
If shares are correctly priced then the purchase of a share is a zero NPV transaction. If this is true then,
the rationale behind mergers and takeovers may be questioned. If companies are acquired at their
correct equity position then purchasers are breaking even. If they have to make significant gains on the
acquisition, then they have to rely on synergy in economies of scale to provide the saving. If the
acquirer (or the predator) pays the current equity value plus a premium, then this may be a negative
NPV decision unless the market is not fully efficient and therefore prices are not fair.

5. Validity of the current market price

If markets are efficient then they reflect all known information in existing share prices and investors
therefore know that if they purchase a security at the current market price they are receiving a fair return
and risk combination. This means that under or overvalued shares or market securities do not exist.
Companies shouldn’t offer substantial discounts on security issues because investors would not need
extra incentives to purchase the securities.
6. Fundamental analysis

Rigorous analysis of the company’s business fundamentals and strategies in order to identify potential
intrinsic value that is unknown by the market, therefore, the share prices are still under-valued.
However, there are many talented and competitive fundamental analysts and so, other analysts will also
know about the under-valuation as well.

7. Charting or technical analysis

Prediction of share price movements by assuming that past price patterns will be repeated. Charts that
track the moving averages of share prices to eliminate day to day fluctuations, in order to detect a pattern
that may show prices are on their way up (buy decision) or on their way down (sell decision). However,
research has shown that share prices appear to move randomly, i.e. move up or down in equal chances,
regardless of what has occurred on previous days.
8. Random walk theory
Consistent with the fundamental theory of share values, in that a share price should have an intrinsic
value that depends on the business performance and expectations of investors. Assumes that all relevant
information is available to all potential investors, who will act upon it rationally. Share price movements
reflect new information as they become available and are acted upon rationally by investors, therefore,
share prices will fluctuate from day to day around the intrinsic value.

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 Question 2: Explain why it’s difficult to test for strong form efficient

Strong form level of Efficiency

This level states that price reflects all the available public and private information i.e. past, present and
future information. If the hypothesis is correct, then, the publication of information that was previously
confidential should not have impact on share prices. This implies that insider trading is impossible. It
follows therefore, that in order to maximize shareholders’ wealth, managers should concentrate on
maximizing the NPV of each investment. Tests that have been carried out on this level have
concentrated on activities of fund managers and individual investors. If the markets have reached the
strong form levels, then fund managers cannot consistently perform better than individual investors in
the market.
Timmermann and Granger, 2004, explained that the difficulty of acquiring the private information in
order to test and stated that "Strong form efficiency can be tested indirectly, e.g. by considering the
performance of fund managers and testing if they manage to earn profit net of risk premium after
accounting for the cost of acquiring private information, The presence of strong form efficiency on the
market implies that it is impossible to achieve above-average profits when having access to a full set of
information. Therefore, access to fundamental information, information about the stock price as well as
knowledge of non-public information does not guarantee the development of a long term, profit-making
investment strategy. One can talk about the strong-form efficiency market when all the information, both
public and non-public, is immediately reflected in the stock market prices. The overall approval of this
form of efficiency indicates that the investors with access to general information, as well as those having
access to non-public information, are not able to “beat the market” and achieve abnormal rates of return.
The presumption is that the recommending institutions have access to non-public information.
The analysis was carried out on the basis of a simplified assumption that financial institutions issuing
recommendations could also use information not available to the average market participant e.g. non-
public and confidential information. This assumption does not imply that having such information is a
necessary condition for developing stock recommendations. Moreover, it is important to mention that
law prohibits exploiting non-public (inside information) or confidential information in conducting
transactions on the capital market

The strong form efficiency hypothesis seems to be intuitively false. The public and non-public
information cannot be reflected in the price of a stock seeing that it has not reached the market yet and

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has not been discounted in the current price. The assessment of the strong form efficiency of a market is
usually limited to conducting an analysis of the achievements of institutional investors, as they were
subjects with privileged access to non-public information and sophisticated investment tools, and then
comparing these achievements (usually) to the weighted-capitalization market index. Along with the
elaboration of Markowitz’s theory, the CAPM model became a benchmark for comparing profitability
of investment fund performance. In the study conducted by Jensen (1969), the results of the analysis
showed that investment funds achieve abnormal rates of return; however, taking into account the
payment of fees and expenses, the researcher concluded that “on average the funds apparently were not
successful enough in their trading activities to recoup even their brokerage expenses”. This indicates that
activities undertaken with the use of relevant information do not guarantee generating profits exceeding
the average rate of return.

In the study conducted by Jaffe, 1974, produced contrary results to Jensen’s as presented above. This
research showed the possibility of achieving profits superior to the market average by using non-public
information, and therefore rejected the hypothesis of the strong form efficiency of a market.

TEST OF STRONG FORM EFFICIENCY

Strong-form financial market efficiency implies that securities prices fully reflect all relevant
information, both historical and public, and private or insider information. Prices immediately react to
new information, so the chances of finding undervalued and overvalued securities are random. This
implies that the market is “unbeatable” and that active investment strategies are in vain. The basic task
of strong-form market efficiency tests, also known as tests for private information, is to determine
whether insider-based trading yields above average return. Numerous studies by Jaffe, 1974; Finnerty,
1976; Seyhun, 1986; Betzer and Theissen, 2009, give the affirmative answer, i.e. prove that insider
trading brings risk and transaction-cost-weighted above-average return. With the help of privileged
information, insiders buy stocks before their price rises and sell them before the price drops. The results
of these studies provide evidence against the validity of strong-form EMH. However, this is evidence
based on unlawful behaviour, which significantly diminishes its value. Insiders cannot make high returns
without taking the risk of being arrested, because insider trading in many world countries is forbidden by
law.
Alternative evidence relates to the performance of mutual funds. These institutional investors invest
knowledge, time, and money to collect information about the company performance. The collected

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information is not publicly available, as it is private, and it, unlike insider information, is not in conflict
with the law. Numerous studies claiming that mutual funds fail to generate above average return are
solid proof of the validity of strong-form EMH. On the other hand, studies suggesting that mutual funds
can “beat” the market are a counter argument to the validity of strong-form EMH. As an example of
profitable insider trading, studies dealing with finance often point to transactions carried out on the
American capital market by one of the most successful arbitrators of all time, Ivan Boesky. Boesky
invested money in stocks of companies expected to be taken over by other companies. His continued
success was secured by privileged information about the takeover, which he received from an
investment banker, whose bank organised the financing of such transactions. When a banker found out
that a company planned the takeover, he would inform Boesky thereof, who bought company stocks
being taken over and sold them after the stock price rose. Boesky was profitable because he knew about
the company takeover before the rest of the market. The U.S. Securities and Exchange Commission
(SEC) quickly accused him of insider trading, for which he was sentenced to three years in prison, a fine
of 100 million dollars, and a ban on trading in securities, Mishkin and Eakins, 2012. Many brokers have
brought large sums of money to their clients by trading on the basis of privileged information provided
by Value Line employees. Value Line is an information centre that provides advisory services to
investors, classifying companies in five groups, depending on the assessment of their future
performance. The employee who prepares press information knows the Value Line recommendations
before the press and official publication. They may sell the unpublished data to brokers of large
brokerage houses, who use it when trading for their clients, thus achieving excessive returns. Many
brokers earned large sums of money in this way, after which they were arrested, Elton et al., 2011,
Seyhun (1986) also tests insider trading profitability, based on 60,000 insider transactions conducted on
the US capital market during the period 1975-1981. He concludes that, with the help of privileged
information, insiders successfully anticipate changes in stock prices and achieve high return. At the
same time, the author tests the claim that investors can earn above-average return by simply reading the
Official Summary, which the SEC publishes based on company reports. However, research results
indicate that outsiders, by tracking publicly distributed insider information, cannot generate risk- and
transaction-cost-weighted above average return. In other words, outsiders cannot make use of publicly
available information on insider transactions to achieve above-average return. These results are in favour
of the validity of semi-strong-form market efficiency. Seyhun (1986) points out that different insider
have information of different quality. Insiders who are in a better position in the company and who are

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better informed about overall company developments, such as department managers, board chairman,
etc., are more successful in anticipating future stock price changes, compared to small shareholders and
company employees. It is generally accepted that perfectly efficient markets are not a realistic picture of
reality. Laws that prohibit insider trading confirm the absence of the validity of strong-form EMH best.

Reference

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Malkkiel B., 2003. The efficient market hypothesis and its critics, Princeton University, CEPS Working
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Pettit, R.R., Venkatech P.C., 1995. Insider Trading and Long-Run Return Performance, Financial
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