Efficient Market Hypothesis

Efficient Market Hypothesis

Efficient market theory states that the share price

fluctuations are random and do not follow any regular pattern. EMH holds that security prices fully reflect all available information at any time.
Individual and professional investors buy and sell stocks Perfectly competitive securities market:
New information arrives at market independently and randomly. Both buyers and sellers adjust rapidly to new information. Current security prices reflect all relevant risk / return information.

under assumption that intrinsic value differs from market price.

The accuracy and the quickness in which the market

translates the expectation into prices are termed as market efficiency.

Two Types of Market Efficiencies

Market efficiency: The expectations of the investors regarding the future cash-flows are reflected on the share prices. The swiftness with which the market translates the expectations into the market price is called market efficiency.
Operational efficiency: Operational efficiency is measured

by factors like time taken to execute the order and the number of bad deliveries. Efficient market hypothesis does not deal with this efficiency. Informational efficiency: It is a measure of the swiftness or the markets reaction to new information.
New information in the form of economic reports, company analysis, political statements and announcement of new industrial policy is received by the market frequently. Security prices adjust themselves very rapidly and accurately.

History of the Random-Walk Theory

French mathematician, Louis Bachelier in 1900 wrote a paper suggesting that security price fluctuations

were random.
In 1953, Maurice Kendall in his paper reported that stock price series is a wandering one. Each successive change is independent of the previous one. In 1970, Eugene Fama stated that efficient markets fully reflect the available information. He suggested that the efficient market hypothesis can be divided

into three categories.

Random Walk Theory

Random Walk: Irregular pattern of numbers that defies prediction.
Random Walk Theory: Concept that stock price movements do not follow any pattern or trend. Random Walk With Drift: Slight upward bias to

inherently unpredictable daily stock prices.

Beating the Market

Superior portfolio performance
Beating the market in terms of

earning above-market investment returns with market like risk. Earning market like returns from a portfolio with below-market risk.

EMH & Technical Analysis

Technical

Analysis: Examining historical stock prices and trading volume to predict future prices. Practitioner of technical analysis.

Almost all studies indicate that such focus on past trends is worthless

Chartist:

Forms of Efficiencies
According to Eugene Fama they are divided into three categories:
Weak form of EMH

Semi-strong form of EMH

Strong form of EMH

The level of information being considered in the market is the basis for this segregation.

Market Efficiency
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.

Levels of Information and the Markets

Weak Form of EMH

The type of information used in the weak form of EMH is

historical prices.
Current prices reflect all information found in the past prices

and traded volumes.

Future prices can not be predicted by analyzing the prices from

the past, because everyone has access to the past prices, even though some people can get these more conveniently than others.
Buying and selling activities of the information traders lead the

market price to align with the intrinsic value.

Semi-Strong Form
The security price adjusts rapidly to all publicly available information. The prices not only reflect the past price data, but also the available information regarding the earnings of the corporate, dividend, bonus issue, right issue, mergers, acquisitions and so on. In a semi-strong form efficient market a few insiders can earn a profit on a short run price changes rather than the investors who follow the nave buy and hold

policy. If the market has to be semi-strongly efficient, timely and correct dissemination of information and assimilation of news are needed.

Strong Form
All information is fully reflected on security prices. Information whether it is public or inside cannot be

used consistently to earn superior investors return in the strong form. Any information whether it is inside or public cannot be used to earn consistent superior returns. It means that security analysts and portfolio managers who have access to information more quickly than the ordinary investors would not be able to use it to earn more profits. It represents an extreme hypothesis which most observers do not expect it to be literally true.

Essence of the Theory

Successive price changes and changes in return are independent and the successive price changes are randomly distributed. Stock prices quickly adjust themselves to any available new information. There may be market imperfections like transaction costs and delay in the dissemination of information but they due not result in any particular investor to earn market beating returns consistently. The prices may move randomly but it does not indicate that there would not be any upward or downward trends.