Features of Efficient Market Hypothesis - Essay Example

Features of Efficient Market Hypothesis Introduction This research report is written with the objective of having an understanding of the efficiency of financial markets in light of the efficient market hypothesis or EMH theory in financial markets. An efficient market is one in which the market price is an unprejudiced estimate of the real value of the investment (Malkiel, 2003, p.59). Features of Efficient Market Hypothesis a) Market Efficiency does not mean that the market value is equivalent to the true value. All it states, is that the errors in market price is unbiased, which means prices of stocks can be lesser than or greater than the true value as long the deviations are random. b) Random Deviations from the true value implies that there is an equal probability that the stocks can be overpriced or underpriced, and these deviations are not correlated to any observable variable c)If the deviations of the market value are random it means that no investors will be able to find any overpriced or underpriced stock no matter what investment strategy he chooses to use. The EMH theory provides a deep insight into the efficiency of financial markets. The Assumptions of EMH EMH states that markets in financial sector are efficient in information. As a result one cannot earn returns over and above the average return of the market provided that the information is available when invested. The following are the underlying assumptions of efficient market hypothesis. Investors are rational in their decisions Markets nature is rational There will be no taxes as they have no role in financial decisions The efficient Market hypothesis can be classified into three parts - weak, strong and semi strong. Three forms of EMH The ‘weak form’ of the efficient market hypothesis identifies prices of tradable assets like stocks, property and bonds etc, which reflect all information that was available to the public in the past. In other words, say for example, the past prices of stock A is reflected in its current stock price. ‘Semi strong form’ of the EMH states that the current prices shall reflect both the prices that are available publicly as well those prices that change instantly to show new information. The ‘strong form’ of the efficient market hypothesis is the strongest form of efficiency of financial markets. It is of the view that information, public or private in nature, is reflected through the stock prices, in the market. Thus even insider information cannot put the investor in an advantageous position (Fama, 1970, p.383). EMH and its role in explanation of asset pricing with respect to a firms debt and equity As already discussed the efficient market hypothesis makes the assertion that asset prices reflect all the information available in the market. Now we shall explain as to why it is not able to adequately explain asset pricing with respect to debt and equity. The efficient market hypothesis is the right platform to start when one is thinking of asset price formation. However evidences have suggested that it has been unable to explain some features of market behaviour. The market prices at times are subjected to misalignments which can exist for a prolonged period of time (Fama, 1991, p.8). Random Walk Model The random walk model is one of the versions of efficient market hypothesis which assumes that successive prices are independant of each other. It also assumes that price changes in succession are distributed identically (Malkiel, 2004, p.3). Asset prices should fluctuate at random in response to the unexpected news in the market. Prices exhibit trends from time to time, in such a manner, that the total returns on risk free asset are in line with risk levels of holding it. Even in such cases deviations in asset price from trend must be unpredictable. Evidences show that under these cases the hypothesis is approximately true. While returns on stocks are predictable partially both in the long and short run, the extent of predictability is generally less compared to the deviations in the returns (Fama, 1965, p.37). The second question has been observed is that the asset prices are at times misaligned – that is they remain at a far distance from those which are consistent with the economic fundamentals for long periods. This may lead to increase in the economic cost which will in turn lead to economically unproductive investment and consumption decisions. It is worth understanding the effects of results for misalignment of asset prices, in the longer run. Evidences suggest that asset prices respond quickly to new information but their movements are near to the random walk, and the fund managers hardly ever outperform the market at consistent levels. This indicates that the asset prices are in line with the fundamentals (Fama, Fisher & Roll, 1969, p.2). In reality, this evidence has little significance on whether prices of assets are in line with the fundamentals. For example let us look at an asset market where prices are subjected to long lasting misalignments, although they are closely related to their fundamentals. If the misalignments are growing gradually the short behaviour of the price of the asset can look alike to that of an efficient market. Thus, it means that the price can be responsive to new information and can show movements which cannot be distinguished from the random walk (Jensen, 1969, p.170). Conclusion The introduction of efficient market hypothesis was a major intellectual advantage. It is a powerful tool for analysis of asset prices and has provided means for exploration of their behaviour. However, twenty years of research and experiences of asset market has made it controversial. In certain cases, the hypothesis continues to give right answers, if not on the dot at least to close approximation. It has been observed that asset prices in short run are closely related to random walk and new information is made available in the asset price. But despite of some of these features, asset behaviour is harder to merge with EMH. Longer run misalignments represent largely the failure of EMH (Scholes, 1972, p.182). In the stock market the price of close funds is difficult to understand as a result of efficient market. The inability of the EMH models in explaining movements of exchange rates have weakened the capacity of EMH to provide a suitable description of the market. Thus, although the EMH is a right concept to use for asset price formation, academic research and asset market claims that it fails to explain some important aspects of asset market behaviour (Fama, 1999, p.380). References Malkiel, B., 2003. The efficient market hypothesis and its critics. [Pdf]. Available at: http://www-stat.wharton.upenn.edu/~steele/Courses/434/434Context/EfficientMarket/malkiel.pdf . [Assessed on 22 January, 2013]. Malkiel, B., 2004. A Random Walk Down Wall Street. Norton.  Fama, E., 1965. The behavior of stock market prices. [Pdf]. Available at: http://www.ifa.com/Media/Images/PDF%20files/FamaThe_Behavior_of_Stock_Market_Prices.pdf. [Assessed on 22 January, 2013]. Fama, E. Fisher, L, M., and Roll, R., 1969. The adjustment of stock prices to new information, International Economic Review. Fama, E., 1970. Efficient capital markets: a review of theory and empirical work. [Pdf]. Available at: http://www2.egi.ua.pt/cursos_2005/files/F/Eugene%20Fama.pdf. [Assessed on 22 January, 2013]. Fama, E., 1991. Efficient Markets II. Wiley. Jensen, M., 1969. Risk, the pricing of capital assets, and the evaluation of investment portfolios. [Pdf]. Available at: http://www.empirical.net/wp-content/uploads/2012/04/Jensen1969.pdf. [Assessed on 22 January, 2013]. Scholes, M., 1972. The market for securities substitution vs. price pressure and the effect of information on share price. [Pdf]. Available at: http://www.e-m-h.org/Scho72.pdf. [Assessed on 22 January, 2013]. Read More