Efficient Market Hypothesis - Assignment Example

?Efficient Market Hypothesis Inserts His/ Her here Efficient Market Hypothesis The EMH (Efficient-market hypothesis) in finance affirms that financial markets are performing efficiently on the basis of certain information. Consequently, one cannot systematically accomplish returns on risk-adjusted basis, in surplus of mean market returns, or on the basis of information accessible at the time of investment. The development of EMH goes back to the 1960s as Paul A. Samuelson and Eugene F. Fama developed their versions of EMH. Surprisingly, from two distinct research objectives both of them formulated independently the same central opinion of market efficiency. In contrast to Samuelson’s path to the EMH, Fama’s seminal papers (1965, 1969, 1970) were based on his concern in evaluating the statistical attributes of stock prices and in concluding the debate amongst technical and fundamental analysis. Among the foremost to apply digital computers to perform empirical research in the field of finance, Fama operationally defined the EMH by pointing structure on several information sets accessible to market players. The efficient-market hypothesis necessitates that the agents should expect rationally that on average the overall population is correct (although if no individual is) and each time new pertinent information comes out, the agents should update their anticipations appropriately. Moreover, agents are not needed to be rational. EMH permits that on facing novel information, some investors may under react while some, on the other hand may over react. But, they are necessitated by EMH to react in a random manner that follows standard normal distribution. So, the overall impact on market prices may not be constantly exploited to attain more than usual profit, particularly, while keeping into consideration the transaction costs (including spreads and commissions). Therefore, any individual may be perceived to be incorrect regarding the market but, market, on the contrary, as a whole is considered to be always correct. Three levels of hypothesis The efficient market hypothesis can be commonly stated in three basic forms. These include weak-form, semi-strong form and strong form efficiency. Each of these provides distinct implications for the way market performs. Weak-Form Efficiency This form of EMH specifies that current prices of assets reflect past volume and price information. The information incorporated in the past series of a security’s prices is completely reflected in its present market price. It is called as weak because the market price is the most accessible information available to individuals and the utilization of technical analysis is forbidden by this form of EMH. Semi-Strong Form Efficiency This form submits that entire available information to the public is incorporated into the prices of asset. Thus the market price of that asset is a complete reflection of all information accessible to the public. This publicly known information includes the past prices as well as the data reported by the company in its financial statements, announcement along with economic and other factors. The Strong-Form Efficiency This form implies that along with the publicly available information, the insider or private information is also reflected in an asset’s market price. Thus, such a market restricts the inside organization members from gaining unusual returns. Thus, all forms of EMH restrict individuals from attaining unusual returns due to unavailability of information and inhibit the possibility of arbitrage or risk free profit (Fama, 1991). Firm’s pricing of debt and equity decisions and EMH The 2007-2012 financial disaster has contributed to renewed criticism and scrutiny of the efficient market hypothesis. It has been even dismissed as being an ineffective way to study the functioning of financial markets in reality by various economists and financial analysts. Critics have proposed that corporations and financial institutions have the capability to diminish the financial markets’ efficiency by producing private information and declining the accurateness of established disclosures, and by formulating complex and new products which are posing challenges for majority of the market participants to measure and appropriately price them (Malkiel, 2003). The crisis has stirred the very bases of contemporary financial theory. Economists and financial writers were ready in a similar manner to compose obituaries for the EMH. EMH implies for the working of financial markets. It has been regarded as to provide various implications for corporate as well as investment managers like the investors cannot be fooled by using creative accounting techniques, the assets prices in the market are a reflective of the level of information available in the market (Malkiel, 2004). Managers cannot time the issue of equity or debt securities etc., but most of these have been found to have failed. Among the basic tenets that form the framework of Efficient Market Hypothesis include that the information available to the public is being reflected in prices if the asset without any delay, and the information that may affect either beneficially or adversely any of the various financial instruments future price, will be reflected in the present price of the asset (Scholes, 1972). Thus, it ensures restricting the possibility of any arbitrage in the efficient market. However, the efficient market hypothesis has failed to provide the correct prices of a firm’s debt and equity and hence, it may be referred as to have failed to provide any implications for corporate managers. The arbitrage opportunities result in the financial markets due to inefficiencies and in order to capture such opportunities, investors have to assume risk resulting due to these inefficiencies (Jensen, 1969). It has been observed that the world’s renowned companies like WorldCom and Enron scandals resulted in huge losses to investors due to managers duping, by the utilisation of creative accounting techniques. It has also been seen in the present-day financial world that corporations have the ability to time the issuance of their equity and debt instruments by issuing debt when the market is experiencing bearish trend while issuing equity when the market is experiencing bullish trend. Moreover, many firms can cancel the IPOs prior to the opening of the announced issues in case if any unfavourable change occurs in the market against equity instruments like Emaar MGF. Corporations have been also seen to postpone their IPOs on experiencing unfavourable market for offering equity. There have been various incidents reporting the insider trading where promoters and managers have been observed to be benefitting from private/inside information. Conclusion To conclude, it can be said that the notion reflected by the efficient market hypothesis, that the markets efficiency is reflected in the prices of the financial instruments and that the prices of assets are a reflective of the level of information available to the public can be considered to be inappropriate in the real world. Moreover, it does not provide any implications for the actual prices of the assets and hence, can be regarded as irrelevant or useless for corporate managers. In conclusion, the opinion demonstrated here suggests that the theoretical corroborate of the efficient markets hypothesis does not hold sound in reality as all investors are not rational and many may be irrational and this irrationality may be associated across investors and also the strategies for arbitrage may involve risk taking activities, undertaken to eradicate the inefficiencies in the market. References Fama, E. (1965). The behaviour of stock market prices. Journal of Business 2, pp.34-105. Fama, E., Fisher, L., Jensen, M. and Roll, R. (1969). The adjustment of stock prices to new information, International Economic Review 10(1), pp.1-21. Fama, E. (1970). Efficient capital markets: a review of theory and empirical work. Journal of Finance 25(3), pp.383-417. Fama, E. (1991). Efficient markets II. Journal of Finance 49(3), pp.1575-1617. Jensen, M. (1969). Risk, the pricing of capital assets, and the evaluation of investment portfolio. Journal of Business 42, pp.167-247. Malkiel, B. (2003). The efficient market hypothesis and its critics. Journal of economic perspective 17(1), pp.59-82. Malkiel, B. (2004). A Random walk down Wall Street. Norton. Scholes, M. (1972). The market for securities substitution vs. price pressure and the effect of information on share price. Journal of Business 45, pp.195-212. Read More