Market Efficiency Hoyothesis - Term Paper Example

«Market Efficiency Hoyothesis» Table of Contents «Market Efficiency Hoyothesis» 1 Table of Contents 1 Introduction 2 Research Objectives 2 Literature Review 3 Research Methodology 11 Time Schedule 12 References 13 Bibliography 14 Introduction Efficient Market Hypothesis is perhaps one of the most controversial and most discussed theories in the domain of Financial Analysis. Over a period of time, there has been different researchers with different and opposite viewpoints regarding the efficiency of this theory. Controversies range on the efficiency of the financial market in allocating economic resources or using information pertaining to it. In finance, other issues such as speculation, predictability, volatilities and anomalies are not independent and are also very much associated with efficiency issues. A number of studies have been done in empirical finance based on the ‘Efficient market Hypothesis’. This paper aims to offer an insight into the ‘Efficient Market Hypothesis’ with evidence taken from the Hong Kong capital market. There have been a number of researches on this issue and hence there is no dearth of evidence. This study purports to offer a comprehensive analysis of the movement of the stock prices to assess the validity and intensity of market efficiency. Research Objectives The research aims to assess the movement of the stock prices in Hong Kong. The assessment would be done in alignment with the ‘Efficient Market Hypothesis’ framework. To assess the validity of the model, the effect of dividend announcement on the stock prices will be considered. Overall, the research aims to analyze the competence of ‘Efficient Market Hypothesis’ with evidences taken from the Hong Kong capital market. The objectives of this research have been articulated below. To discuss the unpredictability of the capital market under the market efficiency hypothesis. To detect the effect of different pieces of information on the capital market efficiency. To evaluate whether the stock prices fully reflect the dividend announcement of the respective companies. To analyze the level of efficiency in Hong Kong capital market. Literature Review The History Back in the year 1900, the theoretical groundwork for the efficient market hypothesis was established by Bachelier. Later on it was proposed by Maurice Kendell in 1953, almost half a century after the establishment of the groundwork. The research done by Kendell revealed that the stock prices move randomly and there in no ways can it be predicted. The explanation behind such kind of behavior was provided with the help of efficient market hypothesis. Previously, the hypothesis seemed quite unreasonable to the academic community. However, later on research documentation revealed a number of empirical evidences to support its validity in the real world market. The early studies on efficient market hypothesis got the much needed support from the capital asset pricing model of Sharpe (1964), Lintner (1965) and Mossin in 1966. The model has allowed the researchers to price the securities in the efficient market. A large number of these studies have found to be consistent with the efficient market hypothesis. As a consequence, according to Fama, the 1970s markets were considered to be efficient in semi strong form. However, later on uncertainties arose on the validity of the hypothesis which became apparent from Jansen’s article in the year 1978. According to him “… we seem to be entering a stage where widely scattered and as yet incohesive evidence is arising which seems to be inconsistent with the theory” (Palan, 2004, p7). In the later period, a number of anomalies were experienced resulting in intensive scrutiny to further solidify their existence and persistence “until they could no longer be explained away by even the staunchest of supporters of the efficient market theory” (Palan, 2004, p7). Few of these anomalies are the turn off the year effect and the trend of stock prices to show short term momentum and reversal in the long run. The last decade had been a witness to the latter event. However, the rationale is yet to be satisfactorily established. The Issue The ‘Efficient Market Hypothesis’ is one of the most significant paradigms in modern finance. In the early 1970s, the hypothesis had huge acceptance in the financial market. Back in the year 1978, Michael Jensen said, the proposition is based on strong empirical evidence (Palan, 2004). An efficient capital market is one where all the information is available for the investors. The market can be expected to be efficient in processing information. As a consequence, in an efficient market, the prices of the assets would ‘fully reflect’ the available information (Fama, 1976). As per the hypothesis there are three broad types of efficiency level in the market. In the weak form of efficiency, the market index would reflect the historical prices which mean that no participant can indentify mis-priced securities and fetch advantages by analyzing the historical prices. The weak form of efficient market can be said to be the base of the rest two intensified level of efficiency. Undoubtedly, security prices are the most easily available piece of information to the public. So, it can be assumed that nobody can fetch profit from a piece of information, known to all. However, it has been noticed, that in a number of cases analysts study these past stock price series and trading volume to carry on the technical analysis of the stocks (Clarke, Jandik & Mandelkar, n.d.). In the semi strong form of market, all the public information is made available for the investors. In the strong form of efficiency, all the public as well as private information are available to the market participants. Public information include the past prices of the stocks as well as data reported in the company’s financial statements like annual reports, profit and loss statements, filing for the Security and Exchange Commission (SEC). In this efficiency level, investors are also given the access to earnings and dividend announcements, financial state of the competitors, announced merger and acquisition plans. Macro economic factors like inflation level, unemployment rate are significant and the stocks prices are supposed to reflect the same. It is not always the financial data which can put an impact on the stock prices, any information on research and development can also inject mobility in the market pricing. In this case, a considerable effort is required by the analysts to gather and analyze this kind of data. Strong form hypothesizes that stock prices would reflect all the relative information on a respective stock, including the information which is only known to the people associated with the organisation. While considering efficient market hypothesis, it is assumed that the insiders, who have access to the information, prior to it getting available to the rest of the market cannot take any advantage to earn any benefit. The rationale can be explained in two ways. According to the theory, if the people of the organization try to trade it, based on the information, the market would recognize that and reflect the same in the stock pricing. Thus the trade would not reap any benefit to the insiders. In practice, the situation is quite different though. The insider trading rules, as per SEC and other respective regulatory body, prevent the insiders to reap profit from the knowledge availed prior to other market participants. These regulations even prevent the individuals, who are made knowledgeable with the respective organisational information, to gain from the prior information. However, in the academia, the practice is always debatable as in the absence of insider information in the market; the strong form efficiency will be always held true, regardless of the principle of insider information leading to excess return (Palan, 2004). Strong form efficiency can be said to be achieved when the prior two efficiency levels are attained. Back in 1960s and 1970s, the discussion was centered on the scope of the stocks to be independent of each other or to follow the random walk model. In the 1960s, research done by Fama (1965) and Samuelson (1965) revealed a number of evidences which were consistent with the efficient market hypothesis. The price of the stocks followed a random walk model. The expected variations in the equity returns were found to be statistically insignificant (Islam, Watanapalachaikul & Clark, 2005). In the 1980s, the ‘Efficient Market Model’ offered a theoretical base to a number of research activities. In this span of time, most of these empirical studies were concentrated on estimating prices using the historical data. At the same time, these studies also focused on forecasting the prices based on various variables like P/E ratios, which were later introduced by Campbell and Shiller in the year 1987. After that, a number of researches have been held on variables like dividend and yield (Fama and French, 1986), term structure variables. Announcement of a range of events i.e. profit amount, stock splits, sale of an asset, capital expenditure and takeovers can also put an impact on the market prices. The concept To examine the above mentioned issues, it is better to revisit the respective concepts related to the efficient market hypothesis. The hypothesis can be explained with different statements. According to the theory, the market price of the stocks would reflect the true value of stocks. There would not be any arbitrage opportunity as all the investors can avail the same level of information. As a result, the market prices would always reflect the available information. In an efficient market, the security prices must be same as the investment value of the securities. Here the investment value is the summation of the future discounted cash flow of the securities, as estimated by the financial analysts. Another thing, which has the ability to influence the stock price, is the arrival of new information. When any new information about any organisation is made available, the above model makes the respective stock price move accordingly, to reflect the new information (Palan, 2004). Jensen has defined the efficient market on the basis of available information set. In the year 1970, Fama established a general notion to describe how the investors can generate price expectations for the stocks. This notion is applicable to all the three efficient market models; the fair game, random walk and martingale or sub martingale models. The equation can be presented in the following form. (Islam, Watanapalachaikul & Clark, 2005). Where E is the operator to represent the expected value; pj,t+1 is the price of security j at time t+1; rj,t+1 is the return on security j during period t+1, and is the set of information available to investors at time t. The left side of the above mentioned equation represents the expected period end price on the stock j, provided the information is available at the beginning of the period. The right side also denotes the return of the stocks in the forthcoming period; the stocks would have the same amount of risk as that of the stock j. The above equation has led to define the expected return efficient market models as ‘fair game models’. The rationale behind this model is that no trading system, which has been based only on the available information set, can be expected to have the returns over the equilibrium expected returns (Palan, 2004). As per the efficient market hypothesis, since all the information would be available to the market participants, investors cannot gain abnormal profit. The gain can only be attained through chance. The difference between the actual and expected value is represented by the following equation, (Islam, Watanapalachaikul & Clark, 2005) Here, xj,t+1 represents the difference between the actual price at the end of the period and the expected price of the investors, based on the available information. In an efficient market, the difference is expected to be zero. As a consequence, it would be possible to estimate the stock prices. The forecasting error is also expected to be zero. In the ‘Random Walk’ model, Fama asserts that the conditional and marginal probability distribution of the price variable for the next year will be identical or else, the entire distribution would be independent of the currently available information. The sub martingale model can be assumed as a special case of the fair game efficient market model. As per the model, the price sequence follows a sub martingale with respect to the available information sequence (Palan, 2004). The expected returns, based on the available information, are always positive in this model. In the market efficiency tests, capital asset pricing model can often be used to measure the excess security returns over the risk adjusted expected returns. However, there are certain limitations of the model and cannot be assumed as a perfect reflection of real world market. The market model is a single factor framework which has been derived from the multi factor model. The model bears certain similarities with the Capital Asset Pricing Model. According to this model, the excess return can be expressed as the dispersion of the expected return from the risk adjusted actual return. The market model parameters are usually derived by the regression of return of a security based on the market portfolio return. The premise of no arbitrage opportunities has been the foundation of non parametric testing of market efficiency (Jensen, 1978). A number of researchers have tested the market efficiency against the capital asset pricing model. It has been noticed that if the null hypothesis is rejected either of the two models will have its existence (Fama and French, 1989). However, the rejection of null hypothesis has the possibility of emergence from the misspecification of the asset pricing framework. In broader sense, the models of random walk, sub martingale and fair game offer evidences in favour of ‘Efficient Market Hypothesis’. In the absence of arbitrage opportunities, the market participants can only gain from the mispriced stocks. However in efficient market, the mispriced stocks are automatically adjusted and reflect all the related information. Limitation of efficiency “Despite these impressive credentials, several cracks have appeared in the efficient market edifice over recent years” (Palan, 2004, p1). The strict interpretation of the ‘Efficiency Market Hypothesis’ implies that in an efficient market, stock prices are supposed to reflect all the available information. However, a considerable part of the academia has adopted a bit modified version of ‘market efficiency’. The academic community believes in an efficient market where the stock prices reflect the available information to an extent that prevents the investors to earn excess returns net of transaction costs. However, variation has been noted in the composition of the transaction costs considered by various authors (Palan, 2004). A considerable segment of academic community believes that a minimum tolerance band, around the strictly efficient prices, must be defined by the minimum trading commission, paid by the floor traders in the major stock exchanges. According to such interpretation, prices in between the bandwidth can still be considered efficient. Some researchers like Grossman and Stiglitz have argued that some of the information can be expensive for the public. In such an instance, some arbitrageurs can avail some profits by trading in the market. This means if only the information is costless, then only all the investors can avail the same. As it is not possible to avail all the information without any cost, the notion of fully efficient market is also unrealistic. As mentioned earlier, despite of the relative simplicity of the theorem, it has been the ground of a number of controversies. It is less likely that the investors would be able to consistently detect the mispriced securities; here lies the invalidity of the theorem. One can surely argue that with a number of participants, prices are required to adjust in a quick manner to reflect the present information in an unprejudiced way. However, it would be wrong to say that many of the criticism of efficient market theory lie in certain misconceptions about the same. In a paper, Clarke and some researchers have argued against a number of myths on ‘Efficient Market Hypothesis’. Many have an idea that as per “Efficient Market Hypothesis’ one cannot outperform the market; however, it has been noticed that successful analysts have been exactly doing the same. Clarke has tried to give some explanation this kind of events. According to him, “EMH does not imply that investors are unable to outperform the market” (Clarke, Jandik & Mandelkar, n.d). The continual arrival of information can make the prices swing. An investor can “make a killing if newly released information causes the price of the security the investor owns to substantially increase” (Clarke, Jandik & Mandelkar, n.d). According to him, Efficient Market theory claims that investors should not be expected to outperform the market consistently or predictably. Any issue should not arise regarding the efficiency of the market rather the intensity of efficiency is what should demand attention. Research Methodology The research will be based on secondary research. The data would be collected from standard sources like books, journals, newspapers and online financial sites. The daily closing prices would be obtained from the stock exchange website. Other significant data would include transaction volume, cash and stock dividends, total market values and other capitalization changes on each of the stocks. As the research was exclusively based on common stocks, other securities such as preferred stocks, unit trusts, warrants and bonds were excluded from it. For this, research references have been taken from other research papers done by renowned authors. The short and long term behavior of the stocks will be selected. The sampling of the stocks will be done randomly. The data themselves may not be in the appropriate form for the ‘efficient Market Hypothesis’ tests. Therefore, the effect of the dividend announcement and new capitalization issues will be required for the analysis. The models, mentioned in the literature review, would be reviewed in the analysis part to align it with the theoretical models. Time Schedule The total time period for this dissertation has been estimated to be of 1 year, starting from the month of July in 2010 till August, 2011. The jobs that need to be accomplished have been mentioned below along with the estimated time period for each of them. The scheduled duration can change as per the robustness of the specified jobs. However, effort would be given to comply with the time schedule. Job Description Time Period Preliminary Research July, 2010 –August, 2010 Data Gathering September, 2010- November, 2010 Determination of title December, 2010 Draft proposal January, 2011 –March, 2011 Presentation April, 2011 – May, 2011 Draft Dissertation June, 2010 – August, 2011 References Clarke, J., Jandik, T. & Mandelkar, G. No Date. The Efficient Markets Hypothesis. [Pdf]. Available at: http://www.e-m-h.org/ClJM.pdf [Accessed on August 20, 2010]. Fama EF. Foundations of finance. New York: Basic Books, 1976. Fama EF and French KR. Business conditions and expected returns to stocks and bonds. Journal of Financial Economics,1989. Islam, S., Watanapalachaikul, S. & Clark, C. May, 2005. Are Emerging Financial Markets Efficient?. Victoria University. Jensen, M. Some anomalous evidence regarding market efficiency. Journal of Financial Economics, 1978. Palan, S. The Efficient Market Hypothesis and Its Validity in Today's Markets. Germany: GRIN Verlag, 2004. Bibliography Friend, I. Blume, M and Crockett, J. Mutual funds and other institutional investors: a new perspective. McGraw-Hill, New York, 1970. Lo, A. Market efficiency: stock market behaviour in theory and practice. London: Edward Elgar Publishing, 1996. Mills, T. The econometric modelling of financial time series. Cambridge University Press, Cambridge, 1999. Pesaran, H and Wickens, R. Handbook of Applied Econometrics, Volume I: Macroeconomics. Blackwell Publishers, Oxford, 1999. Read More