Business Finance: The Effects of Efficient Market Hypothesis - Coursework Example

There has not been an agreement on the best definition for Efficient Market Hypothesis among the experts for a long time. The ability to explain the expression requires a prior understanding of the term efficient market. According to Eugene Fama (1965), this is a market with a great number of traders who are price takers, rational and whose main goal is profit maximization. The agents are assumed to have equal access to the current information and this leads to a high competition. The competition in turn affects the current and the future security prices, and this means that the prices therefore reflect the available information (Harder, 2010). The above explanation aids in explaining the theory of efficient market hypothesis. The theory states that, due to the markets efficiency, a stock’s price reflects all the relevant and necessary information. This implies that the few investors who try to beat the market will be deterred from doing so since the information they have is also available to other investors. Any efforts done towards improving the deal, through fundamental or technical analysis are hence useless. The following essay is going to evaluate the effects of Efficient Market Hypothesis, its levels and its implication on the pricing of a firm’s debt and equity (Harder, 2010, p. 5). The theory has a non-predictability effect on the stock price. Prices are affected by the different social, political and economical conditions prevailing at a certain time period. This means that the prices will keep changing from time to time. The prices are therefore random. This non-predictability of the prices is what discourages investment strategies (Buffett, 2009). This however does not rule out all the possibilities of beating the market. Several researches on behavioral economics show that there are some patterns that the stock market follows that are sometimes predictable. A case example is where the investors buy undervalued shares and sell them at a higher price. Application of the EMF may be quite difficult since the corporate managers’ main objective is to outperform the market. The managers should have the ability to take advantage of any market inefficiency before it disappears. A proper application of the theory can be enhanced if the managers have sufficient knowledge on the levels of the hypothesis. There are three main levels of the EMF, which include the weak efficiency, semi-strong and the strong efficiency. The weak form of the efficient market hypothesis assumes that the current security prices are a reflection of all the past stock market information. This ranges from the volume of trade, the degree of return, to any other stock market information. The impression brought by this is that there is no relationship between the past returns and the returns projected in the future. The future is random and unpredictable and so are the future prices. This argument rules out the success of the technical analysis in generating abnormal returns ( L M Bhole; Jitendra Mahakud, 2009, p. 44). The semi-strong level of EMF encompasses in it the weak form of hypothesis. The difference is that, in the semi-strong, the security prices carry with them all the public information. This means that in addition to the past rates of return, it also mentions on any earnings, dividends, technological advancement, economical news and any changes in management. This form also informs on the ratios between price and income, available stock, and the asset value ratios. The argument in this type of efficiency is that as long as information has been released to the public, and is available to every investor; its fundamental or technical analysis will not lead to an advantage to the firm. This is because the share prices quickly adjust to any new information (Harder, 2010, p. 6). The other form of efficiency is the strong efficiency. This version assumes that the price of a security accounts for all possible information in the market, that is, both public and private. There is no monopoly in the availability of information, and hence all investors are subjected to the same margin of returns ( L M Bhole; Jitendra Mahakud, 2009). The form rules out the possibility of a case where the directors or the top executives have more knowledge on the stock than the other standard investors in the market. Efficiency Market Hypothesis is a very important tool in capital asset pricing. The integration of the two forms a framework which acts as a basis for financial decision-making. The Capital Asset Pricing Model by William Sharpe (1964) is build upon the EMF. The hypothesis suggests that investors will improve on their performance if they trade in portfolios. They can take a portion of their funds and invest in short-term securities, and raise or lower the expected returns in this manner. This will assist them in reducing the costs that could have been incurred in stock evaluation. The model carries with it the assumptions of the EMH. In an efficient market, the agents are well informed, and the knowledge is homogenous. This leads to their rational behavior. Based on this assumption, investors will readily invest into the market since it is risk free. However, in application, the asset pricing model is observed to produce abnormally high returns contrary to the EMH predictions. EMH therefore does not provide adequate explanation of asset pricing (Fama, 1965). The hypothesis has a minimal effect on the pricing of a firm’s debts and equity. Debts and equity are the ones that determine the capital of a firm. Equity, which is mainly due to sale of ordinary shares, is the main source of finance to a company. It is a residual claim. Debts are contractual claims. The capital structure of the firm is, on the other hand, not very important. Raising the amount of debt will decrease the equity. The division of capital into equity or debt in terms of allocation, given a stipulated amount of capital is hence insignificant. The prices of debts and equity cannot be fully determined by market forces, but by the level of the financial needs of the company. If their prices were to be determined just like the stock prices, profit seekers would exploit the firms. The hypothesis is relatively important to corporate managers. If there is a predictable pattern in the pricing of stock, investors can take advantage of the situation and make greater profits. The hypothesis however comes in to warn the investors from taking measures that may towards market exploitation, if in doing so, they might incur higher costs of transactions that might outdo the benefits they prospect. The EMH is also relevant but on the assumption that the markets are efficient. This can rarely happen in the real world. Markets cannot be wholly efficient. In most occurrences, the market is always a mixture of both. If the market was absolutely efficient, there would be no incentive to seek extra profits (Warren, 2009). The advancement in technology has led to a boost in information availability, but this also has a negative side, in that it does not allow room for proper decision-making. Reference list L M Bhole; Jitendra Mahakud, (2009), Financial institutions and markets : structure, growth and innovation. New Delhi : Tata McGraw-Hill. Buffett, W, (2009), Efficient Market Hypothesis - EM. McGraw-Hill Companies, Inc. Fama, E, (1965), The Behavior of Stock-Market Prices, Journal of Business , 35-39. Harder, S, (2010), The Efficient Market Hypothesis and its Application to Stock Markets, German: München GRIN Verlag GmbH. Warren, B, (2009, september 19), Market Efficiency, Retrieved feb 21, 2013, from investopedia: http://www.investopedia.com/articles/02/101502.asp#axzz2LT6RuOLS Read More