Chapter 14
Efficient Market Theory
Learning Objectives
To know the concept of market efficiency
To understand the random-walk theory
To learn the empirical tests
To comprehend the market inefficiencies
Efficient Market Theory
Efficient market theory states that the share price
fluctuations are random and do not follow any regular
pattern.
The expectations of the investors regarding the future
cash flows are translated or reflected on the share
prices.
The accuracy and the quickness in which the market
translates the expectation into prices are termed as
market efficiency.
Two Types of Market Efficiencies
Operational efficiency: Operational efficiency is
measured by factors like time taken to execute the
order and the number of bad deliveries. Efficient
market hypothesis does not deal with this efficiency.
Informational efficiency: It is a measure of the
swiftness or the market’s reaction to new information.
New information in the form of economic reports, company
analysis, political statements and announcement of new
industrial policy is received by the market frequently.
Security prices adjust themselves very rapidly and
accurately.
History of the Random-Walk
Theory
French mathematician, Louis Bachelier in 1900 wrote
a paper suggesting that security price fluctuations
were random.
In 1953, Maurice Kendall in his paper reported that
stock price series is a wandering one.
Each successive change is independent of the
previous one.
In 1970, Fama stated that efficient markets fully
reflect the available information.
Forms of Efficiencies
They are divided into three categories:
Weak form
Semi-strong form
Strong form
The level of information being considered in the
market is the basis for this segregation.
Market Efficiency
Strongly efficient market
All information is reflected
on prices.
Semi-strong efficient market
All public information is
reflected on security prices
Weakly efficient market
All historical information
is reflected on security
prices.
Levels of Information and the Markets
Weak Form of EMH
Current prices reflect all information found in the
volumes.
Future prices can not be predicted by analysing the
prices from the past.
Buying and selling activities of the information
traders lead the market price to align with the intrinsic
value.
Empirical Tests
Filter rule:
According to this strategy if a price of a security rises by atleast x per cent,
investor should buy and hold the stock until its price declines by atleast x
per cent from a subsequent high.
Several studies have found that gains produced by the filter rules were
much below normal than the gains of the simple buy and hold strategy
adopted by the investor.
Runs test:
It is used to find out whether the series of price movements have occurred
by chance.
A run is an uninterrupted sequence of the same observation.
Studies using runs test have suggested that runs in the price series of stocks
are not significantly from the run in the series of random numbers.
Serial correlation:
Serial correlation or auto-correlation measures the correlation co-efficient
in a series of numbers with the lagging values of the same series.
Many studies conducted on the security price changes have failed to show
any significant correlations.
Semi-Strong Form
The security price adjusts rapidly to all publicly
available information.
The prices not only reflect the past price data, but also
the available information regarding the earnings of
the corporate, dividend, bonus issue, right issue,
mergers, acquisitions and so on.
The market has to be semi-strongly efficient, timely
and correct dissemination of information and
assimilation of news are needed.
Strong Form
All information is fully reflected on security
prices.
It represents an extreme hypothesis which
most observers do not expect it to be literally
true.
Information whether it is public or inside
cannot be used consistently to earn superior
investors’ return in the strong form.
Market Inefficiencies
Announcement effect
Low PE effect
Small firm effect
Chapter Summary
By now, you should have:
Understood the concept of market efficiency
Understood the random walk theory
Learnt the empirical tests
Procured knowledge about the market inefficiency
