Lecture Notes - Efficient Market Hypothesis

Efficient Market Hypothesis

Efficient market can be measured in various ways but the most relevant one is in terms of information processing. The term market efficiency is used to describe the way in which capital markets absorb information. An efficient market is the one in which all available information relating to a particular company is processed quickly and accurately and reflected in share prices.

New information related to a particular company is processed in a rational way and the prices of its shares are adjusted accordingly.

The kinds of information that could be reflected on share prices are the following

·         Profit warning- low profit or losses

·         Dividend announcement

·         Board changes

·         Strikes

·         Winning of new contracts

In order for the market to be efficient, there must be a large number of investors who are prepared to examine the available information relating to a company in the hope of discovering under-priced shares.

Note that efficient market is not the same as perfect market

The efficient-market hypothesis was developed by Professor Eugene Fama at the University Of Chicago Booth School Of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school (Wikipedia)

Consider for example a pension fund manager who discovered that a particular company has made a scientific breakthrough and that would lead to its expected profit doubling in the next few years

·         If the market were not efficient the manager could buy shares in the company at a cheap price from small investors who had not yet discovered the firm’s new circumstances. In this situation the informed investor is gaining at the expense of the uninformed investor

·         In an efficient market however the share price of the company would reflect all information that could be known on the company and hence the informed investor would have to pay ‘fair’ price for the shares.

(FTC Foulks Lynch 2005)

The efficiency of a financial market can be measured in various ways, the most relevant ones being in terms of information processing. Information processing efficiency reflects the extent to which information regarding the future prospects of a security is reflected in its current price

There have been many tests of the efficient market hypothesis (EMH) for the USA and the UK market. For the purpose of testing, the EMH is usually broken down into three categories which are:

·         The weak form hypothesis

·         The semi-strong form hypothesis

·         The strong form hypothesis

(FTC Foulks Lynch 2005)

Weak-form efficient

The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information (Wikipedia). In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. What this means is investors cannot generate unusual profit by analysing past information such as stock price movements in previous time periods, in such a market, since research shows that there is no correlation between share price movements in successive periods of time. Share prices appear to follow a ‘random walk’ by responding to new information as it becomes available.

Semi-strong

The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. This means share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information (Wikipedia). Investors cannot generate abnormal returns by analysing either published information such as published company reports, or past information, since research shows that share prices respond quickly and accurately to new as it becomes public.

Strong form

The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information.  In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers (Wikipedia)

The significance EMH

Efficient market is of great importance to financial management. It means that the results of management decisions will be quickly and accurately reflected in share prices. For example if a firm undertakes an investment project which will generate a large surplus then in an efficient market it should see the value of its equity rise (FTC Foulks Lynch 2005)

1.   The significance to a listed company of its shares being traded on the stock market which is found to be semi-strong form efficient is that any information relating to the company is quickly and accurately reflected in its share price (FTC Foulks Lynch 2005)

2.   Managers will not be able to deceive the market by timing or presenting of any information, such as annual reports or analyst’ briefings, since the market the market process the information quickly and accurately to produce fair prices(FTC Foulks Lynch 2005)

3.   Managers should therefore simply concentrate on making financial decisions which increase the wealth of share holders (FTC Foulks Lynch 2005)

Implications of EMH for Financial managers

1.   Timing of financial policy

·         Financial manages argue that there is a right and a wrong time to issue new securities

·         New shares should only be issued when the market is high rather than when the market is low

·         If the market is efficient how are financial managers to know if tomorrow’s prices are going to be higher or lower than today’s

2.   Profit valuation

·         Managers use require rate of return drawn from securities traded on the capital market to evaluate new projects

3.   Mergers and acquisitions

·         If shares are correctly priced, the rationale behind mergers and takeovers may be questioned (FTC Foulks Lynch 2005)

Exam Type Questions

1.   Define the three forms of the EMH. Which form(s) is/are generally confirmed by empirical evidence?

2.   Describe what is meant by market efficiency

3.   What are the implications of the EMH for financial manages

(FTC Foulks Lynch 2005)