The Concept of Market Efficiency and Empirical Approaches to Test for It - Literature review Example

CRITICAL REVIEW OF THE CONCEPT OF MARKET EFFICIENCY AND EMPIRICAL APPROACHES TO TEST EMH INTRODUCTION The financial markets have evolved significantly since its evolution. Among the prominent theories of the developments since the determinations of the finance as a discipline, the concept of the Efficient Market hypothesis is one that has prevailed to date. Financial literature has developed immense perspectives pertaining to the development of efficient market hypothesis. The distinguished characteristic of the EMH is that despite wide range of literature that claims to the falsification of the EMH theory, the concept still retains the strong acceptance in the finance and almost all concepts and events in the financial market are tested against this concept for adding establishing their respective attributes (Maloney & Mulherin, 2003). The aim of this paper is to develop critical review of the concept of the efficient market hypothesis. The paper is developed in the following sections: Section I: This section covers the concept definition, historical development, assumptions and the types of the EMH. All these aspects alongside determine the associated criticisms. Section II: Critical review of the approaches to test the EMH. Section III: this section wraps up the paper with keynotes of discussion and conclusion in specific reference to Global Financial Crises of 2007. EFFICIENCY MARKET HYPOTHESIS (EMH) The formal definition of the efficient market hypothesis is one that was presented by the Fama and French in 1970 (Sewell, 2011). According to the Fama (1970) the efficient market hypothesis states that financial market is said to be efficient with respect to the information, when the prices set by the market are fully reflective of the impact resulting from such information. In other words, according to the Malkiel (2003), the financial markets can be defined with characteristics of being efficient when formal revelation of the information to the market participants will not result with change in prices as a matter of fact that all the information is already incorporated in the current prices. Furthermore, the change in the currently set prices are would only arise once the new information would land into the market (Ullrich & Ullrich, 2009). The definition of Malkiel (1992; 2003) can be stated as the comprehensive version of the Jensen’s (1978; 1969) idea. Jensen (1978) clearly defined the market efficiency as the state of the market where incremental profits cannot be made by incorporating element of exclusive information in the trading strategies (Timmermann & Granger, 2004). Clearly, the definition put forward by the Malkiel (1992) has three points of emphasis for determining the market as efficient. First, the importance attributed to the information in pricing the units in the financial market. Second factor of emphasis in the definition refers to the capability of the stock market trader or the participants to exploit the exclusive information for generating additional economic profits. Finally, the yardstick to measure the efficiency of market with respect to EMH in term of risk adjusted return net of additional transaction cost (Timmermann & Granger, 2004). Unlike the definitions presented by Jensen (1978) and Malkiel (1992), the proposition concept put forwards by the Fama has many limitations. In fact, Fama was self well aware of the vague component as the fully reflect does not determine any standards for empirical tests (Guerrien & Gun, 2011). LeRoy (1976: 1989) was first to claim the lacking in the definition of the Fama and claimed that definition of the market efficiency as the repetition of same concept in different dimension. The criticism from LeRoy (1976) was also admitted by the Fama (1976). In addition to the criticism about the lacking in the presentation of idea, the first criticism about the idea itself appeared in the year 1973 by Shiller (Guerrien & Gun, 2011). Shiller (2003) pointed to the difference which is statistically significant about the true value and assessed value of the security; where true value is derived from the real variables while assessed value results due to volatility. Hence, the criticism and improvement to the EMH theory has been there since the introduction of the concept. HISTORICAL DEVELOPMENT OF EMH As noted above that formal introduction of the EMH which is employed to date is the definition put forwards by the Fama (1976); however, the real idea dates long back. Girolamo Cardano, Italian mathematician, placed an idea about the equality of circumstances as the fundamentals of the gambling (Sewell, 2011). He claimed that if equality in all aspects is not furnished to the parties in gambling, the players of gambling are either fool or the unjust (Sewell, 2011). The entire 18th century had different definitions for the efficient market hypothesis and the concept of random walk theory was well known to the economists and mathematicians. Sewell (2011) has developed the complete chronology of the development of the EMH. The point of interest across the entire development of the EMH in the referred chronology since its initiation is revolving in different aspects. For example, Keynes in 1936 in his book of General Theory of Employment, Interest, and Money has referred the stock market performance as the beauty contest. Keynes (1936) has referred that investors decision in the contemporary markets of stock are driven by the animal spirit. The evidence across the efficiency of the market are under consideration e.g. Lee, Lee, and Lee (2010) assessed the stock markets for 32 and 26 developing and developed countries from 1999 to 2007 and declared about the non- presence of efficiency. The paper of Sewell (2011) on reporting that EMH has claimed despite wide range of criticism being drawn on the EMH and its component of the fully reflective insists that the idea is false as none of the markets can ever be efficient. The paper further concludes that though the idea of EMH is false but the spirit of the idea is deep and weighted. The across the historical development in different forms, the idea of the EMH has been lingering between the extremes of negation and falsification but it is also important to understand that despite immense criticism, the concept has been playing role of one of the defining attributes of the stock market. Hence, by the time another idea is developed that can replace the concept of the EMH, all the criticisms on EMH holds partial influence. ASSUMPTIONS OF THE EMH Fama’s EMH is based on the three assumptions (Yalçın, 2010): First, investors behave in the rational manner. Second, the set of investors with irrational behavior exhibit uncorrelated and random. Therefore, there exists the poor correlation between the activities of the traders in the market and the impact of the activities of such irrational investors is cancelled out. Third, assumption further caters to the potential presence of the correlation between the trading activities. This assumption refers presence of the correlation in the activities is made use by the professionals who arbitrages and makes profits. Therefore, in the final stage when the arbitrage professionals make profit by buying or selling the market the stocks wit under or over pricing, the market will finally land to the state which is defined as efficient market hypothesis (Shleifer, 2000). Apparently, these assumptions attempt to cater the entire phenomenon in the stock market with respect to the efficient market hypothesis. However, the market evidences have much more to tell that are beyond these assumptions. For example, Black (1986) established about the element of noise in the irrational behavior of the market participants. This in turn affects the behavior of the entire market and general investors’ in the market tends to follow noise than the information pertaining to the stock. The resulting situation is spread across the market which fully contradicts to the assumption by Fama which assumes that irrational behavior is spread across few which is than nullified by few others. Furthermore, the arbitrager who was to play the final role of dealing with the correlation effect is also found to receive an impact from the noise trading in the market. De Long et al. (1990) referred to the market risk which is also known as the noise trader risk that impacts the decision of arbitrager to the take position against the irrational traders. Therefore, the profit that arbitrager attempt to make by buying or selling the underpriced or over priced stocks falls at stake of high risk due to the immense and dominant change embraced in the prices of the stock as a result of correlation and irrational behavior. Shleifer and Summers (1990) declared the perfect arbitrage theory unrealistic and claimed that it is further affected by the risks arising from the fundamentals of the stock as well as the risk that arises from the ultimate non-predictability of the future stock prices. Further, Shleifer and Summers (1990) referred to the role of behavioral finance factors such as sentiments etc (i.e. factors other than noise only) that play role in determining the future prices and cannot be accounted in information. Therefore, complete disciplines are developed for aspects that are beyond the simple assumptions considered by the Fama’s proposition of EMH. TYPES OF THE EMH The efficiency of the market, in accordance to idea of Fama (1976), is based on the role of information set. Kondak, (1997) has determined that Fama while establishing the efficiency status has determined three sub- categories of the market information as past, public and private information. The evidences to the role and presence of information set and its ability to determine the market prices of the security varies, the efficiency of the market has been categorized into three classes which are defined as follows: WEAK FORM OF EMH: Markets are in weak form of efficiency when the stock holders can generate certain level of the excess return by employing the exclusive information available to them into trading strategies. Therefore, prediction of the future return on the basis of the past trend is not effective in the weak form of market efficiency (Bodie et al., 2007). Jones (1993) has determined it in the form of the technical analysis and stated that weak form of analysis falsifies the usefulness of the technical analysis in predicting future returns. However, the criticism to the weak form of market efficiency appears in the form that traders can generate excess return by conducting critical analysis of the fundamentals of the stock as well as insider trading (Yalçın, 2010). SEMI STRONG FORM OF EMH The semi strong form of market efficiency is a movement of market towards the efficiency form. Therefore, in addition to the uselessness of the past information for generating excess return, also the publicly available information about the stocks cannot produce excess return. This public information data information includes the annual reports, investment advisory data and other information that are presented on the public forums (Ullrich & Ullrich, 2009). As the market has moved from the semi strong form of EMH; therefore, the factor of fundamentals that was to generate the excess returns in the weak form of market remains ineffective in this form (Bodie et al., 2007). The critics to this form of efficiency arises when the traders in the strategy employee the inside information and generate excess return (Yalçın, 2010). STRONG FORM OF EMH The strong form of market efficiency refers to the state of the market which is the true representative of the EMH. With this case, the strong form of market efficiency refers that any information inclusion in trading strategies about the stocks cannot generate excess return. This information set that is expected not to produce any excess return includes past, public as well as privately available information (Ullrich & Ullrich, 2009). Brealey et al. (1999) describes this status of the market with strong form of efficiency and states that any the market prices in such states are fair and does not offer any option to the insider trader to generate return over and excess return than other. Therefore, Jones, (1993) has determined the different levels of market efficiency as follows: (Yalçın, 2010) EMPIRICAL TEST TO EFFICIENCY MARKET HYPOTHESIS (EMH) Opponents and proponents of the efficiency EMH has developed range of empirical evidences and tests that are aimed assessing and testing the viability of the ideas. Technically, there are different approaches to categorize the tests; however, this section implies to assess the test on the basis of the traditional categorization of EMH in terms of weak, semi-strong and strong form of EMH. TESTS FOR THE WEAK FORM OF EMH The objective of tests for assessing the weak form of EMH is to determine if the market is able to predict the excess returns by assessing the past trends of stock prices. Among different tests, the Random Walk Hypothesis which includes the test of correlation and the run test, the filter test and the momentum affect test are important developments. Each of the mentioned tests has been tested in different market in varying time periods. Therefore, at one end where Fama (1965a; 1965b) reported evidences supporting the theories, Osborne (1962) presented evidence that contradicted the run test. Similarly, Alexander (1961) Filter test was claimed to be biased due to the irregularities in trading rules by Mandelbrot (1963).  The momentum test in one attempt supported the weak form of EMH while the study of the Moore (1962) revealed negative relations between the stock prices. Finally, in 1985, De Bondt and Thaler reported about the overreaction of the market and supporting the weak form of EMH, also led to the foundation of behavioral finance. Hence, despite the criticism to concept as well as to tests designed to assess it, both are present and are being employed even today. For instance, Nisar and Hanif (2012) tested weak EMH in the four major south Asian markets and also employed above test. TESTS FOR THE SEMI STRONG FORM OF EMH The tests designed for the assessment of the validity of the semi-strong form of market also initiated long back. Various and wide range of techniques were employed for assessing the semi-strong from of EMH. All these techniques include various financial measures that depict the impact on stock prices once the information is public. For example, Lakshmi and Roy (2013) assessed the relationship of the P/E on the stock returns. The study implied measures of like Jensen’s Alpha, Sharpe ration and the Treynor ration based measures an concluded the role of public information in the form of premium associated to the lower priced stocks than ones with high P/E (Lakshmi and Roy). The tests started with Fama, Fisher, Jensen and Roll (1969) test for the assessment of change in stock prices with respect to stock splits, dividends and other related information. Womack (1996) and Green (2006) assessed the role of security analysts’ recommendations in support of the Semi Strong. While Malkiel (2003) evidences the tests that resulted in contradiction to the semi-strong form of EMH. It is important to note that despite majority of the evidences that appeared in favor of semi EMH; however, Fama (1991) still had idea about the lacking and so proposed that cases where the tests that does not evidence support shall be considered to have joint impact on the whole on stock prices. TESTS FOR THE STRONG FORM OF EMH Insider trading information assessment by Jaffe (1974) and Seyhun (1986), performance of expertise of fund manager gained support from Malkiel (1995) while non-acceptance by the Chevalier and Ellison (1999) provided the mixed evidence about the tests that can support or oppose the concept of the strong form of efficiency. Furthermore Oke & Azeez (2012) developed tests for the assessing the strong form of EMH in the Nigeria, but found that market is extensively reflective of the characteristics of the weak form. Therefore, similar to the other forms of market, the strong efficient market hypothesis and its tests have received mixed evidences. Hence, the mixed results from the opponents and proponents of the different forms of market hypothesis have revealed the role of other factors than information only in the market. This fact is also asserted by the evidences where tests similar perspective has once proved the idea while application of the test in other instance has noted contradictory results. Hence, it can be merely defined as the role of the market characteristics than the tests. DISCUSSION AND CONCLUSION WITH SPECIFIC ATTENTION TO STRENGTH OF EMH AFTER GLOBAL FINANCIAL CRISES OF THE 2008 Efficient market hypothesis has been one of the most important concepts pertaining to the financial market dynamics. The fact that the concept still holds position in the financial assessment and literatures is self evidence of the strength of the idea. Each dimension that has been considered in this paper has alongside shed light on the criticism associated with it. Therefore, it is important to mention that critics of the idea have failed to present any theory that is able to replace the concept of Fama despite immense criticism. It is also important to mention that failure of any idea is often strengthened once the major event hits the circumstances and settings in which the idea prevails. With this condition at effect, the EMH has witnessed much financial turmoil and still continues to date. 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