Efficient Markets Hypothesis - Essay Example

Is the Efficient Markets Hypothesis Important to the Trading and Pricing of Financial Instruments The efficient markets hypothesis forms the basis for one of today's major theories of the trading and valuation of financial instruments such as corporate stocks and bonds, as well as many other forms of equity or debt. It is vital for investors, traders, analysts, and others dealing with such instruments to understand how their values are determined. In addition, particularly given the present volatile market conditions, the public and the government need a basis for making vital decisions affecting trading and valuations. In order to discuss the importance of the efficient markets hypothesis, I will first explain the several forms of this theory, relying on two important articles: Efficient Capital Markets II by Eugene F. Fama, The Journal of Finance, Volume XLVI No. 5, December 1991; and Accounting and Capital Markets Research: A Review by Christos J. Negakis, Managerial Finance, Volume 31 Number 2, 2005. These articles summarize the efficient markets hypothesis in its various forms, critique that hypothesis, and cover its relevance. After outlining the efficient markets hypothesis itself, I will review some of the issues surrounding it, touch upon its limitations as an explanation of market behavior, and conclude with its importance today. The essence of the efficient markets hypothesis evolved from an earlier capital asset pricing model or CAPM based on investors' unobservable beliefs about future returns (Negakis, page 2). The CAPM predicts a linear relationship between the expected rate of return on an asset and that asset's systematic risk, often termed "beta." The CAPM 2 model in turn led to the arbitrage pricing theory which is more general than the CAPM by including a set of unspecified factors which influence capital valuations. The CAPM in turn has been expanded into a broader format including such factors as the size of the company and the ratio of book value to market value; this version has gained wider support over the past ten years (Negakis, page 3). The efficient market hypothesis, as defined by Fama going back to 1970, "defines an Efficient Market as the one in which 'security prices fully reflect all available information'". Fama, in 1970, identified three forms of Market Efficiency. In the weak form, no investor can expect to gain from analyzing historical data as that data would already be reflected in capital asset prices. In the semi-strong form, no investor can expect to gain from analyzing publicly available information for the same reason. In the strong form, no investor can expect to gain from analyzing information from any source (Negakis, page 3). The efficient market hypothesis requires the existence of a highly-competitive market. with a large number of very-well-informed traders and in which transactions are costless. It would then not matter how many shares or other capital assets a trader sells - the price would remain unaffected by his actions as the market would already have taken them into account. The market would already reflect all available information, which would be included automatically in the price of the shares or other assets under consideration. The advent of portfolio theory has strengthened the efficient market hypothesis by focusing 3 on the valuation of an entire portfolio of many securities rather than on each one's value. In a fully-diversified portfolio, the trader or investor need not be as concerned over each security or capital asset but rather on the risk and return of the total range of those assets. According to Fama, the strong version of the efficient market hypothesis is unrealistic because by assuming that security prices fully reflect all available information, it further requires " that information and trading costs, the costs of getting prices to reflect infor- mation, are always zero.". A weaker and therefore more sensible version of the theory maintains the capital asset prices "reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed the marginal costs" (Fama, page 1575). It seems to me that the efficient market hypothesis, regardless of its validity, has limited usefulness, as there are no realistic ways of testing it empirically. How can a researcher determine whether or not investors or other capital market participants are fully informed about a particular situation, and are then using that full information as the basis for their decisions in the market Because the efficient market hypothesis, even in its weak form, relies on un-testable behavior by traders and others, it is more a statement of belief than a solid theory. These limitations are profound ones unlikely to be overcome by further research along the lines of the past research outlined by Fama and Negakis. Indeed, it appears that the efficient market hypothesis may well be more wishful thinking rather than providing a foundation to understand market movements and capital asset behavior. 4 The recent extreme volatility of stock markets around the world casts further doubt on the usefulness of the efficient market hypothesis. Were that hypothesis indeed valid, there would surely not be the wild swings in the prices and trading volumes of both individual securities and markets as a whole, as measured by recognized market indexes such as the Dow-Jones Average in the United States. It is not sensible that information about either individual securities or even the market as a whole would have such wide variability from day to day, and even from minute to minute. What else might be moving markets now Commentators and analysts have cited such factors as credit and housing crises, rising inflation, job losses, and particularly reduced economic growth as influencing current market behavior. Nor can government policies in many nations be ruled out as causal factors, particularly when impressions of confusion and indecision abound. Even such events as natural disasters and terrorist incidents cannot be ruled out as making for much uncertainty, which is transmitted to world capital markets almost instantly. Given the wide range of opinions over the causes and effects of each and every one of these factors, it becomes untenable to maintain that markets reflect only solid information available to traders and investors alike. Why would there be "information swings" comparable to the market swings outlined above The efficient market hypothesis has lost credibility now. These increasing doubts over the validity of the efficient market hypothesis should serve as an incentive for further research into the causes of price and trading movements which affect securities and other capital assets. It is vital to be able to explain these movements. Read More