Corporate Finance - Forms of Market Efficiency - Essay Example

? Corporate Finance Corporate Finance INTRODUCTION: To understand capital markets and its functions it is important to delve into the concept of stock market efficiency. This concept deals with the movement in share price in the stock market and the factors affecting the movement. In today’s environment where huge acceleration is a trend in the field of investments, the finance managers need to invest in stocks which value will increase in future, especially those which will increase considerably more as compare to others. Market Efficiency: The term market efficiency is used to explain the relationship between movements in the share price and the availability of information in the capital markets. Market efficiency is a crucial factor in deciding the investment strategies of an investor. If the securities market is efficient, the best estimate and returns will be reflected in the price of the shares and there will be no undervalued securities that would offer higher return than expected. However, opposite could be the case in the weak efficient markets. (WOOD, DASGUPTA & POSHAKWALE, 1995) THREE FORMS OF MARKET EFFICIENCY BY FAMA (1970): In this aspect the most contributing work was presented by Fama in 1970. He formulated a market efficiency hypothesis (EMH) which discussed the three types of market efficiency that can prevail in a capital market depending on the available information in the market. These three forms of market efficiency are (1) Weak form efficiency (2) Semi-strong form efficiency (3) Strong from efficiency. 1. Weak Form Efficiency: The weak form of market efficiency hypothesis asserts that the current stock price reflects all the information related to historical prices or past price movements only. This information includes trading volume, rate of return and market generated information etc. This form of market efficiency assumes that the current stock prices reflect all the past information and no one can earn huge profits by knowing information which is known to everyone in the market. This implies that the future rate of return can’t be predicted by using past rate of return and can’t provide with huge abnormal returns. In order to predict the movement of prices based on the past information a technique called technical analysis is sued widely. (BHOLE. 1982; CLARKE, JANDIK & MANDELKER, 2001) 2. Semi-Strong Form Efficiency: The semi-strong form of market efficiency hypothesis explains that the current stock price reflects all the publicly available information along with the historical information. The available public information includes: stock earnings and prices, declared dividends information, political, economy and company related news, dividend yield ratio, price earning ratios, announce merger plans, available information in company’s financial statements, financial situation of competitors and stock splits etc. The assertion behind this form of market efficiency is the same that no one can earn huge profits by knowing information which is known to everyone in the market that is the information is public. In this way the public information is already absorbed into market prices and the investors can’t yield above average profits in such investments and markets. (BHOLE, 1982; CLARKE, JANDIK & MANDELKER, 2001) 3. Strong form Efficiency: The strong form of market efficiency hypothesis explains that the currents stock price reflects all the available information including public and private information both. It encompasses both the weak and semi-strong form of markets. In this hypothesis the emphasis is on insider dealings. It implies that, when both public and private information is reflected in stock price, the directors or the bunch of individuals in the company who have more knowledge of the company will not be able to benefit from the above average profits. The difference between semi-strong and strong efficiency is that in a strong efficiency market nobody will benefit from the information that has not been made public in the market. The rationale of such market is that the market predicts the movement in the prices in an unbiased manner in which future developments and decisions already get incorporated in the stock prices. (REILLY & BROWN, 1997; CLARKE, JANDIK & MANDELKER, 2001) STOCK MARKET AND INFORMATIONAL EFFICIENCY: Many researchers have favored EMH in theoretical terms. Some works in the field suggest that it can be successful in predicting changes in the prices of stock on the basis of technical analysis and simple trading rules, which is consistent with the findings presented in the weak efficiency market form. On the other hand, the event study suggests that news of acquisition, mergers and such events have the same effect as predicted and the market reacts the same way to new information (CLARKE, JANDIK & MANDELKER, 2001). The EMH theory by Fama suggests that all the information available will be reflected in the price of the stock in capital markets. The theory is based on various assumptions; thus, recent researches and works have raised criticisms regarding the theory. However, this theory brings advantage to the professional traders who constantly gather information in the market and reacts to it, resulting in above average profits. It is important to emphasize that EMH benefits those who take the advantage of the available information in enormously short amount of time i.e. few minutes after the information is made public (FISCHER, 2009). The first criticism regarding the theory is that if many investors rely on the market information and believes in informational efficiency in the stock price, the market prices will stop incorporating the information as too few investors gather all the information and vice versa. The EMH works with only few investors gathering information and making gains from it. Secondly the greatest challenge to the EMH is the insider dealing itself which enforces that few individuals with additional information can gain from this information. This contest the EMH which claims that all market information is incorporated in the stock price and no one could potentially benefit from it (FISCHER, 2009). The EMH approach of informational efficiency in the market is challenged by behavioral finance which claims that the stock prices are affected by individual psychology. In this regard the work of De Bondt and Thaler (1985) found that there is a certain pattern of movement of stock prices which relates to psychological behavior and has very little to do with market information (SOLLIS, 2012; FISCHER, 2009). A market is made up of two types of traders; the informational traders and the noise traders. The informational traders base their decisions on the available information while noise traders make no such efforts and generate errors. Studies suggest that the market which is made of informational traders the EMH is true and it fails in all other markets. In an efficient market the only driver of prices is the new information while this concept fails in the markets where the noise traders dominate the market (FISCHER, 2009). The informational efficiency in the movement of the stock prices can also be affected by the publication effects, which means the way the information is published and presented to the public. For example the informational affect varies if the information is published in the footmarks only or is included in the main body of the disclosures. Some studies suggest that even irrelevant and old news and information can affect the stock prices depending on the way the publication and the disclosure are made. On the other hand, another factor affecting the price is the level and capacity of information processing of the investors. At times the information is subjective and can be interpreted in various ways depending on the investor (FISCHER, 2009). The EMH also suggests that due to informational efficiency in the stock price movement investors can’t gain super profits from these markets. However, there are successful analysts like Peter Lynch, Warren Buffet etc. who have done that. There is another point of argument concerned with EMH that it suggests the new information is reflected in the price of the stock, however practically there is a constant movement seen in the stock prices every day, hour and minute. EMH also presumes that all investors have to technically competent and trained to incorporate the information in the stock price, this assumption is impractical and most of the investors are not the same (CLARKE, JANDIK & MANDELKER, 2001) CONCLUSION: The EMH theory presented by Fama is one of the most widely accepted theories of capital market. It discusses the forms of market efficiency and the availability of information in such markets in relation to its effects on movement of prices of stock. No theory is perfect and similarly there are many evidences and arguments of lots of researches that criticize the theory. However, EMH theory remains the most accepted financial theory in capital markets. Bibliography BHOLE, L. M. (1982). Financial markets and institutions: growth, structure, and innovations. New Delhi, Tata McGraw Hill. SOLLIS, R. (2012). Empirical finance: for finance and banking. Chichester, West Sussex, Wiley. WOOD, D., DASGUPTA, B., & POSHAKWALE, S. (1995). Structural change announcement effects in an emerging market: the case of Indian stock market indices. Manchester, Manchester Business School. CLARKE, J., JANDIK, T., & MANDELKER, G. (2001). The efficient market hypothesis. Available at: < ww.e-m-h.org/ClJM.pdf> [Accessed 9 November 2012] FISCHER, V. (2009). Ad-hoc disclosure- A law and economics approach. Ohio, Grin. REILLY, F. K., & BROWN, K. C. (1997). Investment analysis and portfolio management. Fort Worth, Tex, Dryden Press. Read More