The Efficient Market Hypothesis Essay Example for Free

The Efficient Market Hypothesis Essay In modern financial economics, one of the most essential constructions , which plays a significant role in financing strategy, is efficient market hypothesis (henceforth EMH). Despite the fact that its first theoretical formulation, which was founded by Paul Samuelson in 1960s, is almost five decades old, numerous academic studies have been conducted about it (Alajbeg, Bubas Sonje, 2012). According to Alajbeg et al. (2012), in the middle of 1960s market efficiency was defined by Samuelson as the existence of a complete competition in a market, albeit under an assumption that all participants have equally the same opportunity to access the available information. Furthermore, Fama (1965) cited in Alajbeg et al. (2012) attempts to show the EMH empirically. This essay will try to critically debate all the forms of efficiency and give sensible evidence why most of the forms seem to be illogical in the current economic situations. It will start by introducing how to recognise efficiency and what are the forms of the EMH, following by testing each form in today’s economic circumstances with presenting coherent arguments. Damodaran (2001) points out that market efficiency is distinguished by three different measurements. First is considering the amount and the distance of diverting price from real value in the market. The second measure is by looking at the pace and the quantity of adapting prices to new information which come to the market. Finally, it is measured by determining the possibility of usual gaining higher profits by some investors in the market while they may expose the same rate of risk that other investors reveal. Generally, economists have divided the EMH into three main forms based on the type of the information reflected in security prices. The first type of the EMH is weak form. In this form of efficiency, the only information depending on is the past prices information. However, any other available stock information seems to be invaluable in these markets. As Hillier, Ross, Westerfield, Jaffe Jordan (2010) state no information, apart from the historical prices, is relied on by the investors in the weak form efficiency. In the light of this, a capital market is considered to be w eakly efficient when it contains price information about the past share prices. Hillier et al. (2010) also confirm that predating strategy is unlikely to be able to produce returns in the market operations. Put another way, information for future is not predicted in this form of efficiency. This seems to be a possible reason why these markets are called weak efficiency. The second type of the market efficiency is semi-strong form. According to Ross, Westerfield Jordan (1993), the semi-strong efficiency is the most controversial form among all the three forms. From this perspective, Ross et al. (1993) mention the reason why this form in the markets is more controversial than the other forms is that it warns an expert, who analysis financial information in order to find mis-priced stock, to not waste time in analysing some possibly useless information, for instance, financial statement information because this information is already included in the current stock prices. Brealey, Myers Allen (2011) maintain that in these markets, prices rapidly incorporate whole publicly available information, such as last quarters earning declaration, a proposal of unifying other companies and an unfamiliar matter of stock. In the light of this finding, it can be said that the semi-stro ng market efficiency rely on both historical and public information at the same time (Brealey, Myers Allen, 2008). Strong form efficiency is the final form of efficiency. Ross et al. (1993) emphasise all types of information, either public or private, are more likely to be incorporated in the stock market prices when the market is efficiently strong. Additionally, in this kind of market, it is impossible to determine any incomparable investors who are able continually to vanquish the market (Brealey et al., 2011). Expressed differently, strong competition is highly considered among the investors of the strong market efficiency. Therefore, the crucial investors may not be able to keep their high position in the long-term. According to Brealey et al. (2011), since Maurice Kendall published his controversial paper in 1953 on the behavior of stock prices, a significant amount of financial research has been done to test the EMH. In the light of that background information, both supporting and disapproval evidence has extended to each of the three forms weak, semi-strong and strong. Firstly, in order to test the weak form of this hypothesis, Brealey et al. (2011) evaluate the profitability of some trading rules which is utilised by investors who seek to determine patterns in security prices. Hillier et al. (2010) claim although the share price movements are random, investors tend to notice patterns. However, the existence of patterns in the past price data, which is the main information in weak form efficiency, seems to be unreal, according to Hillier et al. (2010). As an example, Hillier et al. (2010) illustrate the participation between Shell transport and Royal Dutch Petroleum, which randomness is highly predicted instead of pattern in their stock price. Then Brealey et al. (2011:352) demonstrate ‘‘since both companies participated in the same underlying cash flows in 2005, it would be expected the stock prices to have moved in exact lockstep, while the real price of the tow shares sometimes diverged substantially’’. Therefore, Hillier et al. (2010) confirm that the security choices based on patterns of historical price changes would not be as acceptable as random choice. As a consequence of this evidence, it can be assumed that the weak form efficiency seems to be a meaningful form in the new economic environment. Secondly, in examining the semi-strong efficiency, the speed of reacting security prices towards announcements is measured (Brealey et al., 2011). According to this form of efficiency, previous price information would not have any influence on present actual return because this form implies that in an efficient market, historical information has merely reflected in the current prices (Hillier et al., 2010). Whereas, in many empirical cases past information impacts on stock prices. For example, Hillier et al. (2010) highlight the global credit crisis of 2008 which firstly started only from the British bank Northern Rock. Then it slowly continued and cover some other banks, such as, Bear Stearn, the US investment bank, HBOS and Lehmann Brothers. Hillier et al. (2010) also state that it had not stopped unless the short selling would have been temporarily avoided by the US and UK governments. From the light of this empirical circumstance, the semi-strong efficiency is probably no longer a sensible form in todays economy because the standard test requirement, which economists follow , may not be reflected in it. Finally, In terms of testing the strong form efficiency, Brealey et al. (2008) point out that the performance of the managers in the markets is depended on. Hillier et al. (2010) imply that it is more likely to profit from a personal information which the other investors do not have in the market, whilst in the strong efficient market it is unlikely to be profited from this information by their owners. Further to this, Brealey et al. (2011) claims that it is probably more common that a particular manager in a market, who is more clever than the others, could make superior profits. This seems to be an appropriate evidence against the EMH in the case of strong form. Similarly, Damondaran (2001) points out that some investors can earn more profit than the others whilst they have the same chance of risk. Brealey et al. (2011) take a large sample of the US companies in order to test the proportion of annual profits among them from 1926 to 2008. Brealey et al. (2011:349) prove ‘‘since 1926 the stock of the firms with the lowest market capitalizations have performed substantially better than those with the highest capitalizations’’. In the same way, Alajbeg et al. (2012) criticise the EMH because of the effectiveness of some anomalies in the market, for example, January effect, weekend effect and momentum effect. As a result of the aforementioned arguments, it can be argued that the strong market efficiency does not make sense in the current economic situations because of the possibility of out-performance in the market. In addition, the EMH has faced many criticisms. For example, Brealey et al. (2011) mention a stock market bubble in property prices in the US. In a way, the price has almost doubled by 2005. Nevertheless, the EMH considers that prices always equal to the values inside the efficient markets (Brealey et al., 2011). This can also be noticed as an evidence against the EMH. In conclusion, the participants mostly try to exploit each single discovered mis-pricing in the stock market. This competition results in market efficiency (Brealey et al., 2008). There are three forms of efficiency: weak, semi-strong and strong. The weak form efficiency seems to be significant in todays economy because it considers that prices are random and that is proved in the empirical situations. However, the strong form is generally considered to be meaningless because of the out-performance which can be executed by some investors. Similarly, the semi-strong form may be seen as an insensible form of the EMH in the current economy. This form is unlikely to provide the common test demands when it tests to find how rapidly prices respond to the new information. Furthermore, there are many debates about the EMH in empirical situations because of occurring some bubbles and crisis. Apparently, there are considerable arguments about market efficiency along the history of the capital market. Nonetheless, financial market efficiency is constantly under debate. In other words, it is still a challenging issue in the current financial economics (Alajbeg et al., 2012). References: * Alejbeg, D., Bubas, Z. And Sonje, V. (2012)The efficient market hypothesis: problems with interpretations of empirical tests. Financial Theory and Practice. Available at: http://core.kmi.open.ac.uk (Accessed at 17th August 2012). * Brealey, A., Myers, C. And Allen, F. (2011) Principles of Corporate Finance (global edition). New York. Mcraw Hill/Irwin. * Brealey, A., Myers, C. And Allen, F. (2008) Principles of Corporate Finance (nine edition). New York. Mcraw Hill/Irwin. * Damodaran, A. (2001) Corporate Finance: theory and practice. Second edition. United States. John Willey Sons, Inc. * Hillier, D., Ross, S., Westerfield, R., Jaffe, J. And Jordan, B. (2010) Corporate Finance. Mcraw-Hill. * Ross, S., Westerfield, R. And Jordan, B. (1993) Fundamentals of Corporate Finance (second edition). Boston. Irwin Inc.