Efficient Market Hypothesis
Introduction
The efficient market hypothesis is a model for how market perform. A market is said to be efficient if prices in that market reflect all available information. (ElynHolton.com)
A market that is pricing efficient implies efficiency in the processing of information (Fama, 1976; Khoury 1983)
The efficient market idea was first proposed by the French mathematician, Louis Bachelier in his dissertation – The theory speculation in 1930. It did not command much attention until the 1950 and 1960s when other researchers in economics and finance began to arrive at the same conclusion.
Efficient Market Hypothesis was put forward by FAMA in 1970.
The hypothesis was to disprove the view held by the Technical Analyst and Chartists who believed in analyzing historical stock price through charting to enable prediction of future stock price.
FAMA argue that stock price does not follow any particular pattern and future stock price is independent of previous price but is more of perception of investors as to the financial fundamentals of firms and that historical information including historical price are already incorporated into the price which reflect historical information.
In other word it is meaningless trying to manipulate or predict share price that is share prices reflect randomness which is unpredictable.
FAMA identified three forms of efficient market based on level of information incorporated into the share prices.
(1) Weak Form – This is a situation where all historical information are already reflected in the share price.
(2) Semi Strong Form – This describe a situation where all publicly known information are made available about the firm and are already impounded in the share price.
(3) Strong form refers to scenario where all information including priviledge information concerning the future of the firm are already reflected in the share prices.
Theoretical Framework
There are several and different types of theories that have been used to explain/ predict share prices. Such theories include:
(1) Traditionalist/ Fundamentalist Theory – It explained that the intrinsic value of share is based on the fundamentals of a firm and represent the present value of future cash flows in form of dividend.
(2) Technical Analysts/ Chartists – They believe that stock price follow historical pattern and future price can be predicted by analyzing the past share price of stocks.
(3) Random Walk – The protagonist of this hypothesis, Burton Marlkiel (1973) and Eugene Fama (1965) propounded this hypothesis to disprove the position of the Technical Analyst Theory and Chartists. They publish their study explaining that stock price is random and do not follow any particular pattern and effort to predict stock price is an exercise in futility. They support the fundamentalist but are of the opinion that the stock price of each period is independent of another period.
(4) Efficient Market Hypothesis – This hypothesis was put forward by FAMA as improved form of Random Walk Hypothesis. He identified three state of efficient market viz; weak, semi-strong and strong.
Efficient Market Hypothesis (EMH) assert that share price incorporate information and the level of information informs the three level of EMH stated above.
Methological Issues
FAMA identified 3 level of Efficient Market Hypothesis viz weak form, semi-strong form and strong form.
Several tests had been conducted to gather evidence in support or against each of the form.
Weak Form – It is relatively easy to gather data in respect of weak form of EMH as historical share price can be used. A proof of weak form involve testing that day to day security prices are not in a particular pattern. Test conducted by Osborne (1959), Moore (1962), Fame (1965), Fama and Blume (1968) and other researchers in USA and Europe proved that the market is efficient in the weak form but Samuels and Yacout (1981), Ayadi (1983) and Ayo Olowo (1996) studies in Nigeria indicated market is inefficient in the weak form.
Semi-Strong Form – Empirical tests on semi- strong form of Efficient Market Hypothesis usually involve test of change in stock prices around information generating events, such as earning announcement, change in accounting policy, new equity issues and stock splits. Fama, Fisher, Jensen and Roll (1969) were the first researchers to carry out such study and they concluded that Efficient Market Hypothesis is efficient in the semi strong form. Other research study and findings by Kaplan and Role 1972, Scholes (1922) have since confirmed that EMF is efficient in semi-strong form; however Olowe (1996) show that Nigerian Stock Market appears to be inefficient in the semi strong form.
Strong Form – Test of strong form, EMH is more difficult as it involve identification of people that have access to privilege information, including insider dealings some which may be illegal in some countries. The few studies carried out by McDonald (1973), Jaffe (1974), Finnerty (1976), Reilly and Drzycimski (1975) among others concluded that insiders and other people with information not available to the public can outperform the market as such Efficient Market Hypothesis in the strong form is inefficient.
EMF ASSUMPTIONS
(i) Cost of credit is linear and uniform for all investors
(ii) Transaction cost do not exist
(iii) Information asymmetry does not exist
(iv) Investors are rational
There are problems with some of the assumptions underlying Efficient Market Hypothesis as discussed as follows:
(i) Information Asymmetry – Empirical evidence (Patell & Wolfson (1984)) would suggest that news is incorporated into price within minutes, but the question is what kind of news. It is obvious that some of the news might have been misinterpreted, while some may be downright false. In addition some investors remain uninformed and some are gullible. We can conclude information asymmetry is real and may undermine the results in Efficient Market Hypothesis.
(ii) Transaction Cost – In practice, transaction cost exist and vary from person to person. This is capable of affecting the final price placed on the asset (shares).
(iii) Investors are rational – This is far from the truth. Investors are not always rational.
(iv) Randomness – According to Martingale, randomness itself does preclude trend or pattern. He asserted that output from a randomly generated process will typically exhibit trends, repetition even though results are generated from a truly random process. This put doubt on the conclusion that future prices cannot be predicted.
Contribution to knowledge
(i) It encourages confidence in the market because substantial empirical evidence suggest that on the long run, nobody can outperform the market, the market generally speaking is always true and fair in pricing of assets.
(ii) Efficient Market Hypothesis pointed out the limitation of technical analysis and inadequacy from charting.
(iii) Efficient Market Hypothesis analysis enable awareness of the power of information and the need for formalized and systematic information dissemination by firms.
(iv) Efficient Market Hypothesis analysis led to identification of a phenomen known as anomalies that is a situation where unexplained excess income or loss result from stock trading. This open up an unexplained area for further investigation and research to advance knowledge.
Conclusion
The Efficient Market Hypothesis tries to explain why stock market prices appear to follow a random walk (Nial Douglas). EMH express market efficiency in three levels of weak, semi-strong and strong form. Empirical test of EMH by several researchers seem to conclude the EMH is efficient in weak and semi-strong forms but inefficient in strong format.
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