EFFICIENT MARKET HYPOTHESIS

CHA PTE R

LEARNING OUTCOMES
After reading this chapter you will be able to
Hypothesis(EMH)
> Understand theconcept of Efficient Market
EMH
> Understand the basic idea bEhind the notion of
> Explain Random Walk Theory/hypothesis
> Specify different levels or forms of market efficiency
Specify the implications of efficient market hypotheS0S
Explain various tests for weak form of market efficiency
Explain various tests for semi strong formof market efficiEnCy
> Explain various tests for strong form of market efficiency
> Analyze the role of portfolio managEmEnt in an efficient market.

There are three approaches to security valuation- Fundamental analysis,

Technical analysis and Efficient Market Hlypothesis. Chapter 5 discussed
about FundamentalAnalysis, while Technicalanalysis was the subject matter
of Chapter 6. This chapter explains the third approach to security valuation
ie. Efficient Market Hypothesis popularly known as EMH.
Theprevious two approaches to security valuation viz fundamental analysis
and technical analysis explain the process of calculating intrinsic value on
the basis of financialinfornation or predict stock price movement on the
basis of past price and volume data. Both these approaches can be used to
advise a prospective investor as to which securities to buy and when to buy.
The third approach to security valuation viz Efficient Market
Hypothesis
275
Para 7.2
EFFICIENT MARKET HYPOTHESIs
takes a different
for any given view. An efficient
stock stock market is one 276
of the stock. Henceeffectively represents
any time is a the true in which the price
277
FORMS OF MARKET EFFICIENCY Para 7.3

Behaviour stock prices has good time to buyintrinsic

for analystsofand or sell. value or fair price ence market efficiency is also concerned with the speed of adjustment of
academnicians. always been an Security prices to new information. The notion that stock prices fully reflect
behaviour and foundMaurice interesting ared of research all available information is referred to as efficient market hypothesis. An
Prices seem overtime
to evolve
Kendall
no predictable (1953) studied stock price
efficient market is one in which:
prices increase or randomly. pattern in stock prices.
unpredictable. decrease only Randomness
in response to in stock prices implies that
Stock prices already reflect all available information and
- Stock prices adjust rapidly(instantly) to the infusion of new infor
new information
which is mation.
7.1 RANDOM
WALK THEORY (RWT) The basic idea behind EMH is that investors are rational and dermand and
Random walk theory(or supply forces prevailing in the capital market are such that the prevailing
prices follow a random hypothesis) is based on the premise market price happens to be the true worth or intrinsic value or fair price
of the security. Hence at any given point of time, security prices reflect
and unpredictable. In walk i.e. the successive price changes arethat stock allavailable information and achange will occur only if something 'new'
other words it random
are unrelated or
independent eachimplies
morrow's price on the basis ofoftoday's
that successive price changes
other. Hence one cannot
happens. It must be noted that the concept of market efficiency here is
concerned with informational efficiency only. The other two types of market
predict to
or yesterday's price or past
However randomness in price changesdoes prices. efficiency are - operational efficiency and allocation efficiency. EMH is not
If prices aredetermined rationally not imply market irrationality. concerned with the operational or allocation efficiency of the market. Market
then only the new information will cause
them to change. In fact a random walk
efficiency requires free flow of information to all the market participants
would always be the natural result at the same point of time. If there is information asymmetry then security
of prices that always reflect full current informnation. Indeed, prices will not adjust rapidly in case of new information.
if stock prices
are predictable that shows market inefficiency and investors irrationality. 7.3 FORMS OF MARKET EFFICIENCY
The random walk modelcan be given below : Fama (1970) provided three levels or forms of market efficiency viz. weak
P,= Pte, form, semi strong form and strong form. This classification is based on the
different meanings of the term "all available information'.
where P, =Price in periodt
7.3.1 Weak Form Hypothesis
P,, =Price in period t-1
unpredictable In weak form of market efficiency, security prices fully reflect all past pric
e, =A random term which is es and volume information. This version of market efficiency
implies
Change in price trend analysis is useless - one cannot predict tomorrow's price on the that
of previous prices. Hence it is based on the premise that "stock prices basis
have
AP =e, no memory". Further, successive price changes are statistically indepen
MARKET HYPOTHESIS dent and hence stock prices follow a random walk and are
7.2EFFICIENT above shows that stock
prices Astationary time series implies mean reverting nature of non-stationary.
the variable i.e.
or Hypothesis presented be predicted. the mean and variance of the series remains constant
Walk Theory prices cannot overtime. Random
Random changes in stock available Walk theory, as explained above, is another manifestation
walk. Hence prices reflect all of weak form
follow a random hypothesis implies that security information. Hence of market efficiency. Let us take an example, if a
market the inflow of new Since that the price changes over the past many days technical analysts finds
adjust rapidly to
Efficient
'new' information.
i n f o r m a t i o n and
only in case of inflow of security price changes related, as the coefficient of correlation is high andare strongly positively
security prices
will change unpredictable, security
good, then happens
predict future price based on past price data. In thispositive, then he may
information is case, market is not
new' happens to be weak form efficient.
the inflow pof information information
r e d i c t e d . If
new the new
and if d o w n w a r d
instantaneously.

cannot be upward
immediately
adjust
prices will adjust
security
prices will
then the
[o be bad
Para 7.3

Implications EFFICIENT MARKET HYPOTHESIS

of Weak
(1) form
IFthe market is of Market 278 279 IMPLICATIONS OF EMH
Para 7.4

a useless efficient in weak Efficiency

exercise. It is not possibleform then technical
on the basis 7.3.3Strong Form of Market Efficiency
of past to predict analysis becomes eficiency, In strong forn of market
(2) Investors price and volume future price 1his is the highest level of market private (1e.
be it public or consistently
erticiency, security prices reflect all information
fundamnental outperform the market and analyse movemens
may still data. even insiders can
inside information)). It means that no one, not
as fnancial analysis. Therefore publicly
security
returns. AIl information about the
stocks using beat the market or earn superior its price.It is only the inflow of 'new'
statements, company reportsavailable information
important events such 1S already discounted and reflected in
can be and information that can change security prices.
(3) Stock prices used to earn announcements
behave in a random wayprofits in stock market. of
walk. ie. prices follow a Strong torm
random
7.3.2 SemiStrong
Form
This is the second level or
fornm of market efficiency. In
of market efficiency, security Semistrong torm
semistrong form
prices reflect not only past prices
information but also all publicly and volume
available
operating information. This includes earnings information i.e. all financial and
announcements, announce
ments of dividends, bonus issue, stock splits, mergers
any other information which is in public domain. Since and acquisition and
already adjusted for all publicly available information, one security pricesare
cannot outper
form the market using such information. It implies that besides technical Weak Fom
analysis, even fundamental analysis becomesa fruitless exercise in semi
strong efficient market. Let us take an example, A company announces
bonus issue on 1s January, 2015. The stock price behaviour of the company
around t 10 days provide significantly higher abnormal returns for this
stock. It indicates that the market is not immediately adjusting for the new FIG 7.1FORMS/LEVELS OF MARKET EFFICIENCY
informnation regarding bonus issue as 10 days is a long time for the
adjust.
not semi strong form efficient.
ment of security prices. Hence the market is 7.4 IMPLICATIONS OF EMH
Market Efficiency
Implications of Semi-Strong form One of the important implications of efficient market hypothesis is that no
Ifthe market is efficient in semi-strong form then besides technical one can outperform the market on consistent basis over long term. This is
(1) useless. The market price
analysis, fundamental analysis also becomesvalue as can be calculated because security prices anytime reflect their true intrinsic value/fair price.
is always equal to its intrinsic However short term fluctuations or adjustments may provide some gains to
of asecurity
publicly available information. some of the investorsat times. Further, since there is random walk in stock
using past prices as well as the market and earn
or traders can outperform prices, technical analysis as well as fundamental analysis become useless.
(2) Olythose investors access to inside or private information Therefore one cannot yield superior returns on the basis of trend analysis
superior returns who have
have an immediate (ortechnical analysis)or fundamental analysis(Economy-Industry-Company
bad, once made public will
(3) Any news, good or Hence such a newS cannot be used to earn Analysis). Since security prices fully reflect all available information, anytime
effect on stock prices. is a good time to buy or sell. The best investment strategy in an efficient
superior returns. market is Passive Investment Strategy' rather than 'Active Management'.
Passive management implies invstment in market portfolio or index funds
which does not require analysis of individual securities for selection in
Para 7.5
EFFICIENT MARKET HYPOTHESIS
nortfolio. The
risk.investor can invest in
at maket Para 7.5
stock selection, Active management market index and 280
281 TESTS OF MARKET
EFFICIENCY

does not building up i.e. analyzing earn market

yield any superior optional portfolio individual securities return check whether the stock prices follow
Tt must be not. The basic idea here is tosuccessive price changes are
gains in an
efficient andmarket. for unrelated
all inyestorsnoted that Passive portfolio rebalancing a random walk i.e. whether
ie, market have to assume same
return. Imvestors
Mamagement Strategy does not and independent.
() Serial Correlation test (or
autocorrelation test)
portfolio with amnount of risk and mean that serial correlation or autocor
risk free asset can combine this Passive
to suit
earm same return This test checks for the presence of Serial correlation measures
series.
Role of their risk-return Portfolio i.e. nmarket relation in the stock return
between returns in a given
period
Portfolio Management in Eficient
preferences. the degree of association
period. Positive serial coelation
It must be with those in the previous
follow positive returns and
exercise innoted that portfolio
management
efficient market. There
Market
does not become
means that positive returnstend to
negative returns tend to follow
negative returns. Jegadeesh
agement even in is still a role for aredundant and Titman (1993)! found a
momentum effect in short run
in an efficient efficient market. The specific rational portfolio man over aperiod of3 months to 12 months.
They found good or
market include the roles of portfolio
managers stocks continues overtime. Past
(1) Building up following: bad performance of particular
winners tend to be future winners and past
losers tend to be
ensure efficientdiversified portfolios : Portfolio managers need selects to
future losers. Therefore a strategy in which investor return in
diversification to eliminate firm specifc risks. to
(ii) Tax considerations: buy past winners and sell past losers yield
abnormal
ent tax rates and Different types of securities are subject stock market.
different investors also to differ
fall in different income DeBondt and Thaler (198S) reported the evidence of negative
slabs. Therefore there is a need tax serial correlation in return series over long run (3 to 5 years).
tax benefits to the investor. to build a portfolio which maximizes Thus past winners tend to become future losers whereas past
in efficient markets. Portfolio managers can bridge this gap
losers turn into future winners. Therefore the investment
strategy that buys loser stocks and sells winner stocks can
(iii) Building portfolio as per Investors' Risk Profile:
Different inves yield abnormal returns over long run of 3 to 5 years. This re
tors have different risk profiles. Some are mnore risk averse (such turn reversal is attributed to investors' over-reaction in stock
as elderly and retired investors), while others are less risk averse market. Over-reaction effect implies that investors tend to
(such as young and salaried investors). There is a need to suggest over-react to both good news (and hence good performing
portfolio as per investors risk profle which suits the best considering stocks become over-priced) as well as bad news (and hence
his risk-return preferences. For example an all equity portfolio may bad performing stocks becomne under priced). Contrarians in
not suit the requirements of a retired person who wants stability in vestment strategy works well in the long run. In India Tripathi
and Aggarwal (2010) documented to presence of asymmetric
income. over-reaction effect in Indian stock market. Indian investors
tend to over-react to good news but under react to bad news.
EFFICIENCY
7.5 TESTS OFMARKET efficiency
The presence of serial correlation or auto-correlation in return
studies have examined various forms of market series implies that the market is weak form ineffcient.
A plethora of globe. Tests for market
efficiency
(it) Filter rules
markets across the test for.
in different stock efficiency one want to
level/form of market weak Weak form of market efficiency requires that the investment
depends upon which presented in different heads as per strategies based on past price or volune data (i.e. technical
these tests have been
market efficiency.
strong form of
Therefore
1. Jegadeesh N&Titman S (1993), "Returns to Buying winners and Selling Losers: Implications
form, semi strong form and efficiency
for stock market" Efficiency Journal of Finance 48(1), 65-91.
market
weak form of by the 2. De Bondt W. &Thaler, R (1985) "Does stock Market overeact? Joumal of Finance, 403), 793-805
1. Tests of are being used
statistical tests
and techniques form efficiency or
3. Tripathi V. & Aggarwal S. (2009) "over-reaction eftect in Indian Stock Market" Asian Journal
numnber of market is weak of Business and Accounting vol.
A whether the
researchers to test
Para 7.5
EFFICIENT MARKET HYPOTHESIS Para 7.5

analysis) cannot
term. Therefore 282 EFFICIENCY

generate
flter rules above normal returns over
283 TESTS OF
MARKET

prices and
returns. The date
whether market is weak test can be performed along
issue, stock splits etc.
on stock
regarded as
the 'event
day and
after the
hlter, usually a form efficient to check announcement is
prior to and
ate a buy or percentage or not. Afilter rule is :
which is by the Or such an examined over a period is applied.
of + 30 days the period
within gvensell decision. Normally used
are
trader to initi returns
Normally atest window over
range i.e. support andthe prices of stockS move
generated
event day'. abnormal returns are considered to
basis of this range It significant the market is
price generally movesthe flter is decided. resistance level. On the surrounding the event date. then

10% flter rule in the range of For example if a

Rs, 20 to Rs. 40, stock s be semi-strong
form efficient.
the past three
decades a
Anomalies : Over variOus
may be
price remains within ± 10% applied. It means that so long asthen a Market presence of
(i) Tests for researchers have reported the effect, value effect,
of the lower and the number of effect P/E
no action would be upper price level, such as size that small sized
initiated.
this ± 10%, an action to buy But when the price goes CAPM anomalies Size effect implies
or sell the stock is initiated.beyond neglected firm
effect etc.
capitalization stocks in long term.
case the trader will not do In this out-perform large presence of a strong
remains in the range of 20 toanything so long as the stock price stocks the
(2005) reported monthly size premium
Sehgal and Tripathi
22. Once it
will buy the stock. On the other hand crosses 22, the trader Stock market with a
the trader will not do size effect in Indian
anything if the stock price falls from 40 to 36. of around 3.8%. tendency of
effect is the
But once it declines below 36, the trader should sell the stock. Value effect or book
to market ratio value
with high book value to market
This way a number of Buy' and Sell' signals are generated valuestocks or stocks Glamour stocks) or
growth stocks (or
using filter rules. If these flters provide the investor withabove ratio to out-perform value to market value ratio. Researchers
stocks with lower book value effects in
normal returns, then it implies that the market is not weak evidence of both size and
form efficient. have found strong markets. This motivated Fama and
US. and other developed 'Multifactor Asset Pricing Model' in
(iii) Runs Test French (1996)5 to suggest
single factor CAPM. However
in emerging markets
Runs test can be used to check whether successive price place of conditional value effect
changes are random or predictable. Arun is an uninterrupted including India, there is a weak and
Earnings Effect implies that
sequence of price movements in the same direction.
For ex (Sehgal and Tripathi 2007)9. Priceout-perform those with high
price series 20, 22, 23, 25 has only one run because stockswith low P/E ratio tend to
ample the
direction. On the other
of neglected
P/E ratio. Neglected frm effect is the tendencycoverage,
prices are moving only in the upward stocks (ie. the stocks which receive least media and
two runs - one upto
hand price series 20, 22, 23, 21, 20 has stocks
decline upto 20. Similarly one can determine the are ignored by security analysts) to out-perform the
23 and then given price series of a stock. which are widely researched.
actual number of runs (R) in a
runs can be compared with mean Besides above,a number of other anomalies such as seasonality
Then the actual number of whether the two are
runs (R) to check effect, turn of the year effect, turn of the month effect, holiday
or expected number of not. effect, day of the week effect etc. have also been documented
significantly different
or
Market Efficiency for developed as well as developing markets.
Seni-Strong Form of
2, Tests of effhiciency are based on
Event
form of market
Tests of semi-strong market anomalies.
and tests of various
Study Methodology be used to check the 4. Sehgal S&Tripathi V(2005) "Size Effect in Indian Stock Market: Some Emnpiical Evidence",
Methodology : This can Vision-Journal of Business Perspective.
() Event Study effects of earnings, dividends,
mergers, bonus
5. Fame E& French (1996) "Multi-factor Explanations of Asset Pricing Anomalies
announcement
Finance 51(1), 55-84. Journal of
6. Sehgal S.& TripathiV. (2007) "Value Effect in Indian Stock
13(1), 23-36. Market" Journal of Applied Finance,
 284
EFFICIENT MARKET HYPOTHESIS

anomalies casts doubts

The presence of these effects or market in these
markets
on semi-strong form of market efficiency superior
effects to earn
because investors can exploit these
returns. detected,
anomaly is
It has been widely accepted that once an opportunities

it gets disappeared over a period as arbitrage

to take advantage ol
market wants
arise and everybody in the and wipes
anomaly. This behaviour restores equilibrium
the
out the anomaly.
3. Tests of Strong Form is a
presence of strong form of market efficiency the
Although the markets,
phenomenon even in
mature and developed market
rare
do test for it. One wav to test whether the
researchers patterns
form efficient or not is to examine the return
is strong insiders,
behaviour of corporate managemment,
and trading institutional
specialists and mutual funds or large
stock market access to
these investors are expected to have
investors. All
information and analysis skills which is not
superior amount of people are
available in public domain. If these sets of market
generally
significantly higher returns than the is not
able to generate can conclude that the
market
general investors, one
or
strong form efficient.

Sumimnary random walk Sue.

that stock prices follow a
implies
Randonm walk theory
unpredictable.
independent and
changes are reflect fully
security pricesinformation
cessive price implies that
Hypothesis (EMH) new
Effcient Market rapidly to the inflow of
information and adjust mnarket.
allavailable efficiency of the
informational
concerned with weak form, semi strong form
EMH is market efficiency
forms of
three
There are
form. reflect all past price and
and strong
market efficiency security prices
weak form
of
In market.
a weak form efficient
volume information.

no use in
analysis is of analysis in a market
Technical
profitsby using fundamental
superior
make
One can form
efficient.
reflect all past price
which is
weak
market efficiency security prices
form of all publicly available information.
In semi
strong
information
as well as
volume
and