The Efficient Market Hypothesis - Essay Example

REQUIRED (a Expected Return: ABC ords: Expected return = X1P1 = (0.3 x 0.25) + (0.45 x 0.22) + (0.25 x 0.12) = 0.204 or 20.4% XYZ ords: Expected return = X1P1 = (0.3 x 0.14) + (0.45 x 0.18) + (0.25 x 0.20) = 0.173 or 17.3% Standard Deviation: ABC ords: Standard Deviation = [P1 (X1 - Xbar) 2] 1/2 = [0.3 (0.25 - 0.204) 2 + 0.45 (0.22 - 0.204) 2 + 0.25 (0.12 - 0.204) 2] 1/2 = [0.002514] 1/2 = 0.05 XYZ ords: Standard Deviation = [P1 (X1 - Xbar) 2] 1/2 = [0.3 (0.14 - 0.173) 2 + 0.45 (0.18 - 0.173) 2 + 0.25 (0.20 - 0.173) 2] 1/2 = [0.000531] 1/2 = 0.02 REQUIRED (b): Covariance: Cov(X, Y) = [(X1 - Xbar) (Y1 - Ybar)] /n - 1 = [(0.25 - 0.204) (0.14 - 0.173) + (0.22 - 0.204) (0.18 - 0.173) + (0.12 - 0.204) (0.20 - 0.173)] / 3 - 1 = - 0.04 Correlation Coefficient: rxy = Cov(X, Y) Sx * Sy = -0.04 0.05 * 0.02 = -40 REQUIRED (c): Portfolio Returns: State: A E[R] = wi E[ri] = 0.7 (0.25) + 0.3 (0.14) = 0.217 or 21.7% State: B E[R] = wi E[ri] = 0.7 (0.22) + 0.3 (0.18) = 0.208 or 20.8% State: C E[R] = wi E[ri] = 0.7 (0.12) + 0.3 (0.20) = 0.144 or 14.4% Expected Return of Portfolio: Expected [rp] = X1P1 = (0.217 x 0.3) + (0.208 x 0.45) + (0.144 x 0.25) = 0.1947 or 19.47% Standard Deviation: p = ([0.72 x 52) + (0.32 x 2%) + (2 x 0.7 x 0.3 x -4.0)])1/2 = 3.27% REQUIRED (d): Mean Return: ABC ord XYZ ord Portfolio 25% 14% 19.5% 22% 18% 20% 12% 20% 16% Mean return 18.5% THE EFFICIENT MARKETS DEBATE "I'd be a bum in the street with a tin cup if the markets were efficient" (Warren Buffet) The Efficient Market Hypothesis There has been significant interest on the part of scholars and academicians as to the causes behind movement of stock prices and their predictability. The Efficient Market Hypothesis suggests that stock prices tend to move because of available information. Basu illuminates that "in an Efficient Capital Market security prices fully reflect available information in a rapid and unbiased fashion" (1977, p663) This suggests that stock price, at a specific moment, reflects all the information that is available and the events that are announced. In this way, only information bears the power to move market prices. There happens to be three levels of market efficiency as delineated by Fama (1970) viz. weak, semi-strong and strong. According to Fama (1970), weak form of market efficiency that market prices are affected by a stock's past performance and previous returns. The semi strong form of market efficiency suggests that market prices reflect all the available information. This degree of market efficiency exists when there are no under or over valued securities in the market and when new information affects market prices very rapidly. The strong form of market efficiency elaborates that all types of information, whether public or private, affects market price of securities. Despite the importance of the Efficient Market Hypothesis, its validity is highly debatable in the literature which is discussed in this essay. Are Markets Efficient According to the Efficient Market Hypothesis, stock prices move in negative and positive directions while responding to information and announcement of events. However, there has been staunch concern owing to market anomalies that indicate deviations from Efficient Market Hypothesis such as Holiday effect [e.g. Ariel (1990)], Monday effect [e.g. French (1980)], November effect [e.g. Bhabra, Dhillon and Ramirez (1999)], January effect [e.g. Bhardwaj and Brooks (1992)] and P/E ratio effect [e.g. Basu (1977)]. Critics are also of the view that movements in stock prices also reflect psychological factors and irrationality on the part of investors [e.g. La Porta, Lakonishok, Shliefer, and Vishny (1997), Shleifer and Summers (1990) etc.]. There has also been significant evidence that economic conditions great affect stock returns [e.g. Schwert (1989)]. The following paragraphs examine the Efficient Market Hypothesis in the light of these deviations. January Effect One of the most important anomalies of market prices and returns happens to be the January effect. According to this hypothesis, stock prices display an abnormal behaviour in the month of January as compared to other months. Bhardwaj and Brooks illuminate that there is strong evidence suggesting a relationship between the month of January and high stock returns. After considering the effect of differential transaction costs for the period between 1982-1986, the authors find that "the low-price stocks are generally found to be associated with significant negative excess returns while the high-price stocks had significant positive excess returns" (1992, p573). The January effect denies the applicability of Efficient Market Hypothesis because of the fact that without any significant disclosure of information, the stock prices change. The distinguished returns for high and low priced securities also refuse the significant impact of information on stock price movement in January. November Effect Critics of Efficient Market Hypothesis question its validity because of abnormal stock returns in the month of November. Bhabra, Dhillon and Ramirez (1999) investigate into the 'November effect' in the light of Tax Reform Act of 1986 in which significant change in the stock returns is found because of the fact that shareholders want to realize capital gains and losses. The authors suggest that "November is not a month of significant disclosure of information and there is no reason to expect that the November effect is primarily due to information releases" (p10) January effect might mislead academicians to believe that abnormal stock returns in January are outcome of information release in the month. However, because there is no significant information release in November, there is enough evidence that abnormal returns take place because of November Effect which negates the validity of Efficient Market Hypothesis. Holiday Effect There also happen to be abnormal stock price behaviour immediately prior to holidays. Ariel (1990) suggests that there is a significant relationship between high stock returns and holiday effects. There are signs of significant returns on the days before holidays because of closing of risky positions on the part of short sellers. The author reports that "the mean return on the trading day immediately before holidays differs significantly from the return on all remaining trading days." (p1615) This further leads one to question the validity of the Efficient Market Hypothesis because high returns before holidays do not result from any significant announcement of events or availability of information whereas the EMH suggests that stock prices move only in response to information. Monday Effect The Efficient Market Hypothesis is also put on trial due to negative stock returns mostly observed on Monday. The research conducted by French (1980) illuminates that as compared to other days of the week, market returns are evidently negative on Mondays. It is also called the Weekend effect. It is interesting to note that this deviation takes place not because of some significant information release on Mondays but due to the weekend effect. An observation of this fact establishes evidence that stock prices move regardless of any announcement of news or information on Monday. P/E Ratio and Stock Price There is another criticism on the market efficiency on the basis that P/E ratio affects a stock's price and leads to significant changes. Basu (1977) finds a relationship between P/E ratios and stock returns. Stocks with low P/E ratio are considered undervalued depicting sound investment prospects. This leads to significant increase in price of low P/E ratio stocks and decline in the price of high P/E ratio stocks. The author also suggests that "a finding that returns on stocks with low P/E ratios tends to be larger than warranted by the underlying risks, would be inconsistent with the efficient market hypothesis" (p663). Thus, the effect of P/E ratio on stock price also leads to criticism of the EMH. Psychological Factors and Investor Irrationality The Efficient Market Hypothesis is also challenged by certain psychological factors and irrationality on the part of investors which provide evidence that stock prices can move drastically without any announcement of events or information. Shleifer and Summers (1990) report that type of investors also affect stock prices to a great extent. In market, there are both rational and irrational investors, the former take investment decisions in the light of information analysis whereas the later invest on the basis of noise and fragile information. These irrational investors cause stock prices to move abruptly and demonstrate abnormality. Therefore, there is staunch criticism that stock prices move greatly in response to investor sentiment rather than on the basis of information. Economic conditions Economic conditions such as booms and recessions play a great role in determining prices of stocks and bonds. A study conducted by Schwert (1989) suggests that prices of stocks, bonds and derivatives are greatly responsive to economic conditions. The prices of these assets will move with booms and recessions even without any significant information available in the market denying the validity of the Efficient Market Hypothesis. For instance the author propounds that recessions lead to greater fluctuations in price as compared to normal economic conditions. Thus, in such a case all of the public and private information has little role to play in moving market prices. Conclusion The above essay debates that Efficient Market Hypothesis does not always hold good because of several market anomalies as well as investor behaviour. The market efficiency hypothesis has been evaluated in the light of market anomalies such as Monday effect, Holiday effect, January effect, November effect, P/E ratio effect, irrational investor attitude and economic conditions. The movement of stock price in response to such effects and factors suggests that stock market does not always move with the announcement of events or availability of information. In other words, it can be said that markets are not perfectly efficient. References Ariel, R.A. (1990), "High Stock Returns before Holidays: Existence and Evidence on Possible Causes," The Journal of Finance, 45(5), December, pp. 1611-1626 Basu, S. (1977), "Investment Performance of Common Stocks In Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis," The Journal of Finance, 32(3), June, pp. 663-682 Bhabra, H.S., Dhillon, U.S., and Ramirez G.G. (1999), "A November Effect Revisiting the Tax Loss-Seiiing Hypothesis," Financial Management, 28(4), Winter, pp. 5-15 Bhardwaj, R.K. and Brooks, L.D. (1992), "The January Anomaly: Effects of Low Share Price, Transaction Costs, and Bid-Ask Bias," The Journal of Finance, 47(2), June, pp. 553-575 French, K.R. (1980), "Stock returns and the weekend effect," Journal of Financial Economics, 8(1), pp. 55-69 Shleifer, A. and Summers, L.H. (1990), "The Noise Trader Approach to Finance," Journal of Economic Perspectives, 4(2), pp. 19-33 La Porta R., Lakonishok, J., Shliefer, A. and Vishny, R. (1997), "Good News for Value Stocks: Further Evidence on Market Efficiency, Journal of Finance, 52, pp. 859-874 Read More