Efficient Market Hypothesis - Essay Example

Implications of Efficient Market Hypothesis Introduction In an efficient capital market, the current stock or share prices fully represent the information relating to stocks and shares, including the information about the risk as well. in the year of 1970, Eugene Fama provided survey material, ”Efficient Capital Markets,” in which it was believed and promoted that the securities markets were extremely efficient enough to reflect the full information about the stock market and the about the individual stocks as well. Lo and MacKinley (1988) found positive autocorrelations for prices of shares. And on the other hand, Caporale and Gil-Alana (2002) outlined that returns on stock have permanent time series properties. Additionally, efficient market hypothesis is divided into three types-weak-form, semi-strong form and strong form efficient markets. All these three types of efficient markets are based on certain assumptions and certain hypothesis. The weak-form efficient market hypothesis is based on assumption that current prices of stocks represent the full historical information, particularly mentioning that the technical analysis would not yield superior risk-related and risk adjusted amounts of returns. On the other hand, the semi-strong form of efficient market hypothesis assumes that the stock prices fully reflect and represent the public information, mentioning and indicating that the fundamental analysis would not bring the yield of superior risk-adjusted returns. The strong-form of efficient market hypothesis is based on the assumption that the prices of securities reflect both private and public information, highlighting and indicating that the investors would be able to earn higher risk-adjusted returns. But, these three forms of efficient market hypothesis have proved some serious limitations. And these serious limitations proved their existence in the year of 1987 when the event of market crash occurred. Is it possible to rationally explain the causes of the market crash of 1987? Is it appropriate to say that markets were efficient enough to represent the prices of stocks in the required way? But, that was not end of it; rather they continued to be part of the finance history. In the year of 1990, the Internet Bubble totally invalidated the rationale behind the use and application of efficient market hypothesis. On the basis of hindsight, it is clearly evident that the equity valuation, which normally heavily depends on the unpredictable and uncertain future predications, was based on irrationality and irrational and unsupportable claims. In the subsequent parts of this piece of work, first the concept and theory of efficient market hypothesis would be clearly explained and highlighted. After that part, its implications in terms of validity and applicability of this theory would be critically accounted for. Definition__________________________________________ An efficient capital market is defined as a capital market in which the current price of a share or stock fully and totally represents and reflects all the stock or share related information, including the information of risk (Schweser, 2004). Furthermore, an informationally efficient capital market is defined as a capital market in which a price of security or stock rapidly and fast adjusts as soon as a new piece of related information is arrived. This piece of definition of an efficient capital market hypothesis is based on certain assumptions, and they are: First, a considerable number of participants, who are there to increase profit or returns on stocks, tend to understand and analyse and and give value to stocks and securities, and these participants are independent of each other. Second, any piece of new information appears in a capital market in a random fashion; and pieces of information are also announced independent of each other with regard to timing as well. Third, securities and stocks investors and fund managers quickly and rapidly start estimating the prices of stocks so as to reflect their understanding of the newly received and newly arrived piece of information. Most importantly, it is believed that market efficiency does not assume that the market participants truly and correctly adjust the prices of stock; consequently, some participants under-value or over-value the prices of stocks. Fourth, the risk is incorporated and included in the rate of expected return in a price of stock. There is no single type of efficient capital market exists; rather, there are three levels of efficiency exist ( Fama, 1970; Fama and French, 1989) Types of efficient market hypothesis________________________ Weak-form efficient markets______________________________ The historical market information is being reflected by a stock price. The weak-form of efficient market hypothesis is based on an assumption that stock prices truly represent and reflect the currently available historical market information. As a result, the prices of past and the volume of information find no link and relationship with the future movement and future direction of the prices of stocks. The weak-form of efficient market hypothesis may not be plausible in many situations (Poterba and Summers, 1988; Pesaran and Timmermann, 1995,2000). Semi strong-form efficient markets_________________________ The quick and fast stock prices adjustment of the public information provides its base to this type of efficient market hypothesis. The semi strong form of efficient market hypothesis strongly believes that the stock prices instantly change or more clearly adjust themselves as soon as the new piece of information is available: It is highly required that such piece of information must be available publically. Semi strong form market is of the view that stock prices reflect all stock market and non-market public information. This type of efficient market concludes that the investors have a particular limit to their stock returns; the investors cannot earn more or excessive returns on the stock using the tool of fundamental analysis. Strong-form efficient markets_____________________________ This type of market fully reflects both publically and privately available information. The strong-form efficient market proposes that the stock prices considerably and fully represent all pieces of information that are circulating in the public and private sources. This type of market is included of pieces of information coming from all the possible and relevant sources like; private (inside a company), non-market public and market. On the basis of this definition, it can be concluded that no group of investors or fund managers can have a monopolistic access to information relevant and related to the stocks. Furthermore, this type of efficient market tends to be an example of prefect market where all information is easily available to everyone and no amount is paid to receive an access for a particular type of information. Some differences and some similarities can be deduced from the above different types of efficient market hypothesis. The most significant and important similarity is that under no circumstances any investor would be able to earn excess amount of returns either the investor is in weak-form, semi-strong form or strong-form efficient market. This similarity remains the same and equally applied to all types of efficient capital markets. On the other hand, there are some differences among them. For instance, in a weak-form capital market, the hypothesis assume the prevalence of past or historical information; on the other hand, a capital market assuming the stock prices are based on market, non-market public and private sources is called as strong-form efficient market. Limitations of efficient market hypothesis___________________ This theory is not free of limitations. The critics of this theory believe that the market prices could not have been determined by the group of rational fund managers or rational investors rather it was the force of psychological considerations that must have performed and played the significant role. Aggregately, there was no major or significant economic change during or before the Market Crash of the year of 1987. All the relevant forces of general economic environment were doing and performing their role as they were performing before or during the period of the Market Crash of 1987. On the basis of this clear economic situation visible from this point of time at the time of market crash, how could the market stock prices be efficient at the beginning and during the middle of the October? The market inefficiency was evident from the events of the Market Crash of 1987 and from the Internet Bubble of the late 1990s. Both these high profile incidents in the finance history clearly highlighted that those who believe and promote the efficiency of capital markets and its mechanism are required to prove the logic and inefficiency surfed by these events! The suggested events happening before the Market Crash of 1987 were not represented by the stock prices. Rather, stock prices were looked indifferent about those events. The Market Crash of October 1987_________________________ The efficient market hypothesis proved its inefficiency in the Market Crash of 1987. First, two months before the mid of October, the yields of the long-term Treasury bonds upgraded from the level of 9 per cent to the level of 10.5 per cent, but instead of having a positive effect according to the theory of efficient market hypothesis, the relevant stock markets did not prove the worth and significance of the theory of efficient market hypothesis. (Malkiel, 2003). Second, early in the month of October 1987, then Secretary of the Treasury James Baker had hinted to support and encourage a further decline in the exchange rate of the value of the dollar, showing negative implications for foreign and local investors. Third, early in the month of October, “merger tax” was threatened by Congress. This threat would have made mergers expensive and consequently, this would have ended the upward movement of merger boom. On the face of it, these events cannot be properly represented by the stock prices. Some events were positive and some were negative for the community of investors. But, the aggregate economic situation during and between the entire period did not come across with any significant negative change; almost each and every sector and part of the economy was performing normally. The Internet Bubble of 1990s_____________________________ Popping of the Internet Bubble of late 1990s proved to be another example of market inefficiency. The behavioralists termed and referred that serious decline as an example of irrational market. And in the decade of 1990s, academic leaders’ discussion was shifted from econometric analyses of time series towards the human nature and human psychologically (Shiller, 2003).The irrationality can be proved by many ways. For instance, valuing equity depends on unpredictable and uncertain future forecasts. Even all the market members rationally determine the price of stock prices as the current or present value of all future expected cash flows; it is yet possible for excesses to incur. With the help and support of hindsight, it is unequivocally understandable that un-supportable claims were being announced relating to the increase and growth of the Internet. Also, “new economy” concept which was greatly boasted of did not sustain its existence for a longer period of time and crashed. References 1. Fama, EF 1970, "Efficient capital markets: a review of theory and empirical work", Journal of Finance, Vol. 25 pp.383-417. 2. Fama, EF, French, KR 1989, "Business conditions and expected returns on stocks and bonds", Journal of Financial Economics, Vol. 25 pp.23-49. 3. Poterba, JM, Summers, LH 1988, "Mean reversion in stock prices: evidence and implications", Journal of Financial Economics, Vol. 22 pp.27-59. 4. Pesaran, MH, Timmermann, A 1995, "The robustness and economic significance of predictability of stock returns", Journal of Finance, Vol. 50 pp.1201-28. 5. Pesaran, MH, Timmermann, A 2000, "A recursive modelling approach to predicting UK stock returns", The Economic Journal, Vol. 110 pp.159-91. 6. Lo, AW, MacKinley, AC 1988, "Stock market prices do not follow a random walk: evidence from a simple specification test", Review of Financial Studies, Vol. 1 pp.41-66. 7. Caporale, GM, Gil-Alana, LA 2002, "Fractional integration and mean reversion in stock prices", Quarterly Review of Economics and Finance, Vol. 42 No.3, pp.599-609. 8. Shiller, RJ 2003, “From Efficient Markets Theory to Behavioral Finance,” The Journal of Economic Perspectives, Vol.17, No.1, pp.83-104 9. Malkiel, BG 2003, “The Efficient Market Hypothesis and Its Critics,” The Journal of Economic Perspectives, Vol.17, No.1, pp. 59-58 10. Schweser, 2004, “Corporate Finance, Portfolio Management, Markets, and Equity,” Kaplan: USA. Read More