Efficient Market Hypothesis - Essay Example

Efficient Market Hypothesis An investment theory states that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the Efficient Market Hypothesis (EMH), this means that stocks always trade at their fair value on stock exchanges, and thus it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Thus, the root of the EMH is that it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. (Investopedia, 2006, para.1) Although it is a basis of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. While academics point to a large body of evidence in support of EMH, an equal amount of disagreement also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossibility according to the EMH. Critics of the EMH also point to events such as the 1987 stock market crash (when the DJIA fell by over 20% in a single day) as evidence that stock prices can seriously deviate from their fair values. (Investopedia, 2006, para.2) Wikipedia defines the Efficient Market Hypothesis (EMH) similar way. An assertion exists that financial markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or property, already reflect all known information and therefore are accurate in the sense that they reflect the collective beliefs of all investors about future prospects. The Efficient Market Hypothesis implies that it is not possible to consistently outperform the market - appropriately adjusted for risk - by using any information that the market already knows, except through luck or obtaining and trading on inside information. It further suggests that the future flow of news (that which will determine future stock prices) is random and unknowable in the present. The EMH is the central part of Efficient Market Theory (EMT). (Wikipedia: Efficient market hypothesis, 2006, para.1) Efficient Market Theory is a field of economics, which seeks to explain the workings of capital markets such as the stock market. According to University of Chicago economist Eugene Fama, the price of a stock reflects a balanced rational assessment of its true underlying value (i.e., rational expectations); its price will have fully and accurately discounted (taken account of) all available information or news. The theory assumes several things including perfect information, instantaneous receipt of news, and a marketplace with many small participants (rather than one or more large ones with the power to influence prices). The theory also assumes that news arises randomly in the future (otherwise the non-randomness would be analyzed, forecast and incorporated within prices already). The theory predicts that the movements of stock prices will approximate stochastic processes, and that technical analysis and statistical forecasting will most likely be fruitless. (Wikipedia: Efficient market theory, 2006, para.1-2) It is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may under react. All that is required by the EMH is that investors' reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable. (Wikipedia: Efficient market hypothesis, 2006, para.2) There are three common forms in which the Efficient Market Hypothesis is commonly stated: Weak Form Efficiency. The information set includes only the history of prices. Semi-Strong Form Efficiency. The information set includes all information known to all market participants (publicly available information). Strong Form Efficiency. The information set includes all information known to any market participant (private information). (Fama, 1970, pp. 383-417) 2) Explain the relationship between spot and forward exchange rate: in an efficient market the forward rate is an unbiased forecast of the spot rate. In an efficient currency market, players are rational and all available information is reflected in the exchange rate. Therefore, if all individuals are equipped with the same information about the fundamental value of a currency, have equal chances and no one can make abnormal profits. One of the commonly utilized equations to show this market efficiency where Rt represents the percentage rate of return in period t, Zt represents the excess returns in period t while I represents the information set is: Zt = Rt – E(Rt/It-1) (0) Under the market conditions of EHM, E(Zt/It-1) or the expected excess return in period t using the information in period t-1 is equal zero and is serially correlated. This is consistent with the assumption that in an efficient market that at period t-1, all investors are rational making no prediction error. All investors are faced with the same information set and they know the equilibrium rate of return at period t. According to the EMH, forward rates are useful predictors of future spot interest rates. In the special case of the pure expectations hypothesis, forward rates are unbiased predictors of future spot rates. The more general (and more realistic) case allows for premiums in forward rates, and variation through time in these premiums can make it difficult to assess the predictive ability of forward rates. Fama (1984, pp. 509-528) approaches this problem by running pairs of time series regressions as follows: Hτt+1 - Rt+1 = α1 + β1(Fτt - Rt+1) + εt (1) Rt+τ - Rt+1 = α2 + β2(Fτt - Rt+1) + ηt+τ-1 (2) In these regressions, Hτt+1 is the holding period return for the month ending at t+1 on a τ-month bill. Rt+1 is the one-month spot rate of interest that is available for the month ending at t+1. Similarly, Rt+τ is the one-month spot rate of interest that will be available for the month ending at t+τ. Fτt is the forward rate for month t+τ, observed at time t. The dependent variable in (1) is the premium on a τ-month bill that is realized at time t+1. The regressor in both equations is the forward-spot differential. According to the pure expectations hypothesis, the forward rate is an unbiased estimator of future spot rates. Consequently, the slope coefficient in (2) should be 1.0. Further, since there are no premiums in forward rates in a pure expectations world, the slope coefficient in (1) should be zero. In the more general case where premiums may exist, both slope coefficients can be greater than zero, and the slope in (2) will typically be less than 1.0. 3) Need to explain the econometrics model to test the EMH based on forward premium and empirical results. In exchange rate market the EHM could be tested in the following way. Equilibrium rate of return between forward and spot exchange rates can be given as: ft+kt = set+k + λt (3) where ft+kt is forward contract defined at t and maturing at t+k set+k is expected spot rate at t+k. The model can be expressed in terms of variations: fpt = ft+kt – st Δset+k = set+k – set fpt = Δset+k + λt (4) Rational expectation Δst+k is defined as: Δst+k = Δset+k + ut+k (5) fpt = Δst+k + ut+k + λt (6) where fpt stands for the forward premium and Δset+k represents the first differences of the spot rate. So we can write the regression equation of the following form: Δst+k=a +β fpt+ut+k (7) Concerning the efficiency of the market we test both the un-biasedness and orthogonality hypotheses. In both foreign exchange series we can reject the null hypothesis of orthogonality. The null of rational expectations implies that a=0 and β=0, and in the presence of non-overlapping data the error terms should be serially uncorrelated. If the forward premium is an optimal predictor of the future spot exchange rate, then β=1. If agents are risk neutral and rational it follows that for (7) to be satisfied we would expect α=0 and β=1. If agents are risk averse, however, then a significant constant term in the unbiased equation could reflect a constant risk premium and a significant deviation of β from 1 could reflect a time varying risk premium, irrationality or both. According to Fama’s (1986) results, the risk premium is more volatile than expected future exchange if β Read More