The Concept of Efficient Market Hypothesis - Research Paper Example

Corporate finance Contents Contents 2 Introduction 3 Main body 3 Efficiency of financial market 3 Efficient-market hypothesis 3 Random Walk Hypothesis 4 Possibilities of future bubbles and predictability 5 Conclusion 7 References 8 8 Introduction The concept of efficient market hypothesis came in 1960’s when Eugene Fama introduced this theory. According to this hypothesis, beating the market is not possible as prices are already included and talks about all relevant information. The theory is not at all free from controversies. The hypothesis also tells that buying and selling of securities is all about of chances and there is no scope of skills. Recently the global economy has gone through a very critical phase. Currently the global economy is in the recovery mode and going towards right direction but the uncertain global financial situations and its interrelated relationship can be a reason for worry. Here in this paper a critical analysis will be done on whether the financial markets are efficient or not. Different theories will be discussed for further analysis. Additionally future probabilities of global financial crisis will also be discussed. It will be done on a step by step basis. Main body Efficiency of financial market The market efficiency can be defined as the level to which market responds to all available and relevant information. Efficient-market hypothesis According to the theory of Eugene Fama, markets efficiencies are totally dependent upon information. The hypothesis has mainly three versions. Those versions are Strong, Semi Strong and Weak. Strong form of EMH comments that prices reflect all available public information and also hidden information. Semi strong of EMH states that prices reveal only existing and changing publicly available information. Weak version of EMH tells that prices of traded assets show only publicly available information (Quiry, Fur, Salvi, Dallochio and Vernimmen, 2011). The efficient market hypothesis considers that every investor take all present information in the same manner. This consideration faces lots of oppositions, as stock valuation have some difficulties with this assumption. It is often being noticed that some investors are interested in undervalued stocks and some investors are interested towards growth potentials. It shows that there are huge differences between the ways of thinking of two investors. It is clearly against the theoretical foundations of EMH theory (Ferran and Ho, 2014). It also indicates that with the help of this model ascertaining the worth of stock is impossible under efficient market. As far the efficient market hypothesis, no investor is ever able to gain greater profitability in compared to others, through the equal amount of already invested funds. It further clarifies that equal ownership of information means investors can only achieve same returns. But this assumption is also not true in different cases as there are very wide ranges of returns. It also indicates that different investors have very clear advantages than others. Their returns are also different. According to the EMH it is impossible for investors to beat the market. This is also not true as lots of investors are there who constantly beat the market. Warren Buffet is a good real life example. According to Fama markets cannot be efficient always. According to him attaining full efficiency is something impossible. The theory further states that stock prices need certain time to response with changing information. This theory does not talk about any specific time period. In EMH there is scope of inefficiencies and so, full market efficiency is not possible. Random Walk Hypothesis This is a very important financial theory which state that stock market prices change according to a random walk and for that reason it cannot be predicted. The theory is falling in line with EMH. According to the theory stock price changes follow the similar distribution and are not dependent on each other. This theory state that predictions of future movement cannot be done on the basis of past trends of stock prices. According to this theory stock prices are changed randomly. It also poses same consideration that markets are efficient. Similar to the EMH this theory also comments that markets cannot be beaten without taking additional risks. The theory is totally contradictory with different technical analysis. With the help of technical analysis future stock performances can be forecasted. Different critics of the theory also stated that beating market is very much possible with calculated investments in equity and by the help of proper timing of entry and exit in and from the market. All the above arguments are clearly telling that the Random walk hypothesis is not free from limitations or criticism. All these arguments also reinforce one fact that the market cannot be fully efficient. It can be forecasted and it can be beaten. Possibilities of future bubbles and predictability Lowering interest rate of Greece and America is worrying sign. These post crisis trends are stagnating growth for permanently. It can lead to a future financial instability in the global economy (Brealey, 2007). Crisis period struck the world almost seven years ago. But still the crisis has not been made up totally. In a recently held meeting of IMF in Washington experts across the world showed their considerable concerns regarding low interest rates. Even rates of Spanish long term debts have fallen remarkably and the country is battling hard for stability and on the verge of sovereign debt default. Greece is also severely struck by this situation and their debts have been taken off. Apart from Germany and France all the other European economies are battling very hard to avoid another crisis but the situation is very sensitive. At first during the beginning of the global financial crisis it was considered that lower interest rates may be a temporary phenomenon but that consideration is totally wrong and now days it is a very permanent scenario, which can lead to future financial bubbles (Damodaran, 2010). During the time of global financial crisis some emerging economies like India and China did comparatively well, but the present situation has blocked their financial growths also. According to global financial experts glorious days are highly questionable as financial conditions are very uncertain. According to their comments interest rates can settle well below the expected rates. If the situation remains same countries like Spain and Greece will register huge unemployment rate. According to global financial experts present trends are pretty similar with pre crisis periods which can result in similar kind of financial disasters in future. Global stock prices can be changed very quickly. When the interest rates are very low automatically investor will invest their money with higher risks for the sake of higher returns (Slee, 2011). In the course of that, future possibilities of asset bubbles are there which could result in future financial instabilities (Palan, 2007). Recently in their meeting IMF expressed this concern. The global economy is currently not prepared for future growth path; it is still on the risky zone as investors are looking for upward movements of yield. According to the different financial trends long term financial interest rates are not going to go back to the stable position in near future (Amenc and Sourd, 2005). Different political unrests across the world and resultant financial sanctions are even worsening the situation for the future. Significant possibilities are there that the world may experience more bubbles in future. According to both EMH and Random Walk theory it is impossible to beat and predict the market. Predicting these types of bubbles on the basis of past trends is totally contradictory with EMH and Random walk theory (Ang, Goetzmann and Schaefer, 2011). Even Federal Reserve of America assured the world before the real estate crisis (Ranganatham, 2006). According to them everything was under control but all of a sudden everything went out of control. Spanish unique capital control system failed. IMF is still depending on central banks of different countries and on other global regulators. It is depending heavily on micro prudential method for predicting the future bubbles but there is enough scope of doubts in that method, as the bubbles could be very complex and uncontrollable as far as the both above discussed theories are concerned. In this difficult context blue print of BRICS bank can be a silver lining but the idea still in its preliminary stage and the idea have too limited capacity to deal with or predict the gravity of the future uncertain global economic situations. The modern world is interrelated and economic situation varies from country to country (Barucci, 2003). This unavoidable characteristic of modern world has made predictions of future global economic situations more complex. All the above arguments are clearly establishing the fact that predicting future global economic bubbles in the context of market efficiency theories are very difficult, if not impossible. Conclusion According to the two theories of EMH and Random walk market is significantly efficient. Investors have very little scope to show their skills, but during the course of this study it also being observed that markets are not fully efficient. There are relative presences of human trading skills also. It also signifies that these two market efficiency theories can be effective but not free from limitations, as there are significant numbers of controversies against these two theories. It can be easily concluded that as far as market efficiency theories are concerned, it is impossible to predict future bubbles on the basis of past and present data or trends as markets change randomly. References Amenc, N. and Sourd, L. V. 2005. Portfolio Theory and Performance Analysis. Sussex: John Wiley & Sons. Ang, A., Goetzmann, N. W. and Schaefer, M. S. 2011. The Efficient Market Theory and Evidence: Implications for Active Investment Management. Hanover: Now Publishers Inc. Barucci, E. 2003. Financial Markets Theory: Equilibrium, Efficiency, and Information. London: Springer Science & Business Media. Brealey, A. R. 2007. Principles Of Corpte Fin. New Delhi: Tata McGraw-Hill Education. Damodaran, A. 2010. Applied Corporate Finance. New York: John Wiley & Sons. Ferran, E. and Ho, L. C. 2014. Principles of Corporate Finance Law. London: Oxford University Press. Palan, S. 2007. The Efficient Market Hypothesis and Its Validity in Todays Markets. New York: GRIN Verlag. Quiry, P., Fur, Y. L., Salvi, A., Dallochio, M. and Vernimmen, P. 2011. Corporate Finance: Theory and Practice. New York: John Wiley & Sons. Ranganatham, M. 2006. Investment Analysis and Portfolio Management. New Delhi: Pearson Education India. Slee, T. R. 2011. Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests + Website. Toronto: John Wiley & Sons. Read More