Different Forms of Market Efficiency - Theoretical Arguments and Experimental Evidence - Literature review Example

THE DIFFERENT FORMS OF MARKET EFFICIENCY: THEORETICAL ARGUMENTS AND EXPERIMENTAL EVIDENCE. By of the of the Name of the School City, State 23 April 2015 Introduction Efficiency of a market is displayed in financial markets when the market participants operate under favourable conditions (1999). Financial markets are independent institutions where people trade commodities at prices replicating the nature of the market. Market efficiency is essential in market segmentation for this is the determining factor. There are underlying hypotheses like market participants, pricing and information which make market efficiency to be a widely discussed monetary issue. The market prices in these hypotheses reflect information available in the stock market at any particular time. This is because potential investors capitalize on information that has not been exploited in the market (2008). Therefore market efficiency is defined as the state in which the participants enjoy favourable conditions in regard to demand and supply. The participants maximize on the market opportunities at minimum transactional costs. Understanding market efficiency is an important phenomenon for it highlights any perceived inefficient market segments. Such inefficiencies can then be evaluated to make the market prices equitable estimates on the value of investments (2002). This paper discusses the various forms of market efficiencies and articulating the theoretical argument and experimental evidence behind them. Forms of market efficiencies Scholars on market efficiency agree that there are mainly three forms of efficiency. These include weak form, semi-strong and strong form efficiency. The weak form of market efficiency elucidate that the market security prices like volumes of security trade replicate all information relating to trade. This implies that investors do not get abnormal returns on any trading plan pegged on past price movements as the market information is projected from the public information. The weak form of market efficiency also states that all past market prices are totally reflected in the security prices hence no need of carrying out technical analysis to gain extra profits because prices are randomly decided. The semi-strong form of market efficiency suggests that security prices entirely replicate all public information emanating from firms, economic, political and any other source of news. This means if semi strong form holds in a market, then the weak form will inevitably hold except in cases where they cannot hold together. In such instances, investors earn abnormal returns if they make use of appropriate information that the market has failed to justify. Because all the publicly available information is fully reflected in the security prices, analyzing the fundamental data does not better the market for the investors. This form of efficiency hence infers immediate and neutral market response to the pronouncement of news with relevant value. The strong form of market efficiency suggests that security prices completely replicate all information, comprising of private and insider information. Assertions are made that if this form of efficiency holds for a market, the semi-strong efficiency must also hold. However, only semi-strong form of efficiency is likely to hold if the insider information results to abnormal returns. Insider information enables insiders like employees and board members to unfairly override external investors. This is because they get firsthand news and act on it faster before it reaches outsiders. These forms of market efficiency invariably hold for financial markets. It is also possible for two forms of market efficiency to simultaneously hold together except in special cases but depending on the market information. Validity and implications of the forms of market efficiency and connection to price predictability Kratz asserts that these forms of efficiency have different implications on the market (1999). The weak form of efficiency because it is dependent on past behaviour of security prices reduces all efforts to nothing. But for the semi-strong efficiency the validity means interrogating the publicly available information to reduce extra return for sustainable duration of time. However, the validity of strong form efficiency makes it difficult to outpace the market. Hence many fiscal decisions and actions inevitably mislay their meanings. As a result the stock price becomes undervalued. Damodaran reports that an efficient market does not imply investors will automatically outpace the market always by using common strategies. This means that an efficient market may have negative implications for investment plans (2002). The negative implications may include expensive equity research and valuation with no benefits. Also strategic random diversification through stock market with no costs will be greater than strategies that create larger information and execution costs implying no value addition for the top bras. Furthermore, minimizing trading strategies proves superior to any strategy that needs frequent trading. It is worth noting here that market efficiency is viewed as a challenging phenomenon by portfolio managers and analysts. Damodaran also gives other conditions with no implication from the concept of market strategy. These include large deviations of stock prices from the true value which are random. It is therefore not appropriate to argue that no investor will beat the market in any time period as half of them are managing it before any transaction costs. Also, no group of investors will overtake the market in the long term. But due to the large number of investors in the market, there are few lucky ones who manage it since they do not apply similar techniques in their investment plans. Damodaran therefore concludes that the anticipated investment returns will be consistent with the risks involved over the long run in an efficient market. This might be despite the deviations from the expected short term returns (2002). Empirical tests of the efficient market hypothesis Efficient market hypothesis at any particular time implies security prices will entirely replicate the available information (2009). Hence testing of the weak form efficiency has been done through a pattern of nonrandom search in security prices. Any anticipation of a future price shift in regard to recent changes will mean past price movements determining earning abnormal returns. Because historical price changes are assumed to be autonomous with time, the information is already reflected hence cannot earn abnormal profits. This implies that in case of any dependence, extra returns earned will be offset by the transaction costs. Similarly, the test of semi strong form efficiency has been done by evaluating how returns on security fine-tune to certain pronouncements. Such pronouncements are associated with a firm or related to the economy hence security prices instantly replicate information from them. This means that security price is not steadily overvalued or undervalued hence no abnormal returns can be realized. And it applies when considering transaction costs. Moreover it is reported that the test of strong form efficiency is not easily achieved because the inside information to be relied on is not readily available and cannot be accurately verified. However, many versions of insider trading can easily result in abnormally high returns. Violation of market forms efficiency in the financial market Baker and Nofsinger assert that researchers have recorded some aspects of violations on weak and semi strong forms of market efficiency (2010). They report that violations of the weak-form are evident in the calendar pattern because of seemingly systematic difference on the average returns. In such instances, predicting these patterns becomes confusing. Evidence of violation in weak-form of market efficiency is also marked in price patterns. Additionally, there are apparent documentations of violations of semi-strong form of market efficiency. Such violations are based on features like size, expansion of sales and accruals of the market. These features pinpoint firms earning extra returns beyond those anticipated by their standards. Further violations of the semi-strong form underlie the reactions portrayed by investors towards news events. Closer examination of corporate events in the long run demonstrates that market reactions are inefficient unlike in the short term. This means post-earning news results in continued movement in abnormal returns depending on whether the news is good or bad. Connections between efficient market hypothesis and rational behaviour of investors Investors determine the efficiency of a market and hence the market price. Auinger asserts that the basis of efficient market hypothesis is pegged on the investors’ decision making rationality (2015). However, this assertion is challengeable because most investors do not wholly trade on the available market information as it tends to be short-lived. It is also argued that efficient market hypothesis is built on the assumption that arbitrageurs will shift the asset prices to their inherent value as soon as an opportunity shows up. However, behavioural portfolio management advises that arbitrage cannot disregard price distortions. This is due to difficulty in spotting arbitrage opportunities, the dangers it is associated with and limited engagement by participants. Also efficient market formulation assumes that rational investors are unwilling to incur expenses except in expectation of higher returns. Conclusion The functionality of market efficiency implies economic and informational efficiency. The economic efficiency enables investing in assets that yield higher returns at low costs. Also the ability of existing prices to adjust to new information implies informational efficiency (2011). Hence an efficient market can hope for a spot in the future financial market because of active participation by rational profit-maximizers. This is because applying the current and newly upcoming information helps foretell the future values of security prices in the market (2014). References Auinger, Florian, 2015. The casual relationship between the setP 500 and the VIX Index: Critical analysis of financial market volatility and its predictability. Wiesbaden: Springer Fachmedien Wiesbaden. Baker, Kent H. and Nofsinger, John R., 2010. Behavioral finance: Investors, corporations and markets. Hoboken, N.J: Wiley. Besley, Scott and Brigham, Eugene, 2011. Principles of finance. Ohio: Cengage Learning. Bruetsch, Markus, 2009. From capital market efficiency to behavioral finance. Munich: Munchen GRIN Verlag GmbH. Damodaran, Aswath, 2002. Investment valuation: tools and techniques for determining the value of any asset. New York: Wiley. Kratz, Oliver S., 1999. Frontier emerging equity markets securities price behavior and valuation. Boston: Kluwer Academic. Madura, Jeff, 2008. Financial markets and institutions. Mason Ohio: Thompson. Mikolajek-Gocejna, Magdalena, 2014. Investor expectations in value based management. Cham: Springer. Read More