NIKITHA M

1837044

3 MAECO

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT CIA-1

EMPIRICAL EVIDENCE FOR EFFICIENT MARKET HYPOTHESIS

INTRODUCTION

Capital market is a platform for investors to buy and sell securities or bonds in the primary
and secondary market. Businessmen usually prefer to invest in the secondary market because
it deals with long term securities. In order to reap profits these businessmen employ analysts
to assess the performance of the securities that catch the eye. The security analysis is
performed by two methods namely fundamental analysis and technical analysis. The
technical analysis predicts the future price movements of a security by analysing its historical
trading data. This is used to identify patterns, price movements and trading volume.
Fundamental analysis on the other hand calculates the intrinsic value of a stock by going
through the company’s financial statements. The security analysis is performed to identify the
risks and returns associated with a stock. The main objective of the investors in most of the
cases was to yield abnormal profits. They taught that they could achieve this observing the
price movements and forecasting. But Eugene Fama in 1970 proposed that prices “fully
reflect” all relevant information. It means that the prices of the securities entail all the
relevant and known information and it is impossible to beat the market. Such markets are said
to be “efficient”.

MEANING OF EFFICIENT MARKET HYPOTHESIS

The Efficient Market Hypothesis (EMH) was first given by Eugene Fama. This hypothesis
completely dismisses the role of fundamental and technical analysis in outperforming the
market. According to Fama in his book “Efficient Capital Markets: A Review of theory and
Empirical Work”, it is impossible for a stock to generate returns that is greater than the
overall average market return with the universally available information. This essentially
signifies that the stocks trade at their fair value and it is difficult to generate extra profits by
selling overvalued stocks or by buying undervalued stocks. The EMH has three main
propositions: Weak form, Semi-strong form and Strong form. The Weak form hypothesis
states that the current prices have completely assimilated the past prices and the past prices
cannot be used to predict the future price movements. This essentially means that even
technical analysis cannot be used to earn supernormal profits. Semi-strong form hypothesis
argues that stock prices reflect all publicly available information and the prices quickly adjust
to any new information that is out in the market. Here, both fundamental and technical
analysis losses its essence as they fail to yield abnormal profits to their investors. Finally,
Strong form of hypothesis claims that the prices are inherent of both public and private
information. In this case, even insider information disappoints the investor as it is fully
reflected in the market price. This theory has gained a lot of criticism among the scholars.
This kind of an efficient market is deemed to be “ideal and imaginary” by many. The
following piece of work analyses the validity of EMH by reviewing certain empirical studies
conducted by experts.

EMPIRICAL EVIDENCE

The paper by Gupta,N and Gedam,A on “Testing of Efficient Market Hypothesis : A study on
Indian Stock Market” tests the validity of weak form hypothesis. The study took into account
top four stocks each from automobile and IT industries listed in the National Stock Exchange.
The daily data on closing prices for the mentioned stocks were recorded for a period of 3
months (1st January 2014- 31st March 2014) and analysed. Runs test and Serial correlation
were employed to test the independence of stock prices over time. The results portrayed that
the past prices were not able to forecast the future prices and the prices were independent of
each other. This established the validity of weak form of efficiency. Like any other study this
work also has certain limitations. Here, only a single non-parametric test was used for the
analysis and the period of study was not enough to carry out a detailed analysis.

The empirical work by Mobarek,A and Keasey,K is at loggerheads with the study by
Gupta,N and Gedam,A. Their work “Weak form market efficiency of an emerging market:
Evidence from Dhaka stock market of Bangladesh” disproves weak form efficiency
hypotheis. The sample included all the stocks listed in the Dhaka Stock Exchange from 1998
to 1997. The daily stock price data was recorded and observed for the same. The authors had
employed two parametric (Auto-correlation and Auto regression) and two non-parametric
tests (Kolmogrov-Smirnov test and Runs test) to validate their results. All the tests result in
the rejection of null hypothesis of random walk. This shows that the historical prices played a
significant role in predicting the future prices deeming the weak form as inefficient. This is
one of the very few tests conducted on a Less Developed Country (LDC).

Another study to verify the existence of Efficient Market Hypothesis was performed on a
transitioning economy like Baltic economy by kvedaras,Vand Basdevant,O. The study was
conducted on the stock exchanges of three Baltic States namely: Lithuania, Latvia and
Estonia in 2002. The methodology is based on time varying autocorrelation coefficients and
the coefficients were estimated using the Kalman filter. For a transition economy variance
ratio test is more applicable to capture the independence of prices rather than the standard
techniques. The results showed slight inefficiency in the market. The author pointed out the
reasons for slight autocorrelation to be from transaction costs, cost for acquiring information
and a few more. They found the economy to be moving slowly toward efficiency. Therefore,
neither disproves nor approves the validity of weak form efficiency.

The paper by Mlambo,C and Biekpe,N analysed the EMH for ten Stock markets in Africa.
The data on daily closing prices and volumes traded were recorded and observed for the
study. Runs test and serial autocorrelation were employed to study the independence of stock
prices. The results showed that a significant number of stocks rejected random walk. The
reason pointed out for this was less trading time. Since the trading period was limited, the
adjustments in prices were delayed and therefore the stock prices deviated from the state of
independence or random walk. The Kenya and Zimbabwe stock markets were fund to be
significant. Since they are the oldest stock markets in the country, they have incorporated the
historical prices are clearly reflected in their intrinsic value. The authors also argue that runs
test is not just enough to deem a market inefficient since runs test only establish a linear
relationship between the variables. This is because the assumptions of EMH are completely
violated by the runs test therefore a non-linear model is required to investigate the
independence of stock prices.

IMPLICATIONS OF EMH FOR INVESTMENT ANALYSIS

The efficiency of the markets determines the profitability of the investors. The efficiency is
measured by how effectively the stock prices reflect the historical data, private and public
information. Using the information that is universally available the investors with the help of
analysts try to predict the future performance or price movements of the desired stocks. If he
market is highly efficient, any amount of additional information that is already reflected in
the stock prices but unbeknownst to the investor will not be successful in generating super
normal profits. On the other hand, in a highly inefficient market, the investors can take
advantage of additional information to earn extra profits. The validity of EMH is still debated
and a consensus on the accuracy of market efficiency has not been achieved yet.

CONCLUSION

This piece of work has compared and analysed different empirical studies conducted to
support Efficient Market Hypothesis. Mixed results were shown by the studies. This is
because a potpourri of less developed country (Bangladesh), developing country (India),
Transitioning economy (Baltic States) and underdeveloped country (Africa) was taken for
comparison. There are equal number of studies that stand for and against of EMH. This can
be attributed to the inefficiencies in the methodology and the environment in which they were
conducted. The EMH was proposed to establish a fair platform for the participants to
compete and trade. The inefficiency of the markets gives an edge for the privileged over
others. An economy can develop as a whole only when there are fair practices giving equal
opportunity for everyone to evolve. Therefore the stock prices should essentially be non-
forecastable.

REFERENCES

Fama,E. (1969). Efficient Capital Markets: A Review of Theory and Empirical work. Journal
of Finance. 25(2). 383-417. Retrieved from:
https://www.jstor.org/stable/2325486

Gupta,N., Gedam,A. (2014). Testing of efficient market hypotheis: A study on Indian Stock
Market. Journal of Business and Management, Vol.16.28-38. Retrieved from:
http://www.iosrjournals.org/iosr-jbm/papers/Vol16-issue8/Version-3/E016832838.pdf.

kvedaras,V., Basdevant,O. (2002). Testing the Efficiency of Emerging Markets: The Case of
Baltic States. Retrieved from: https://ideas.repec.org/p/eea/boewps/wp2002-09.html
Mlambo,C., Biekpe,N. (2007). The efficient market hypothesis: Evidence from ten African
stock markets. Journal of Investment Analysts, No.66, 5-18. Retrieved from:
https://mpra.ub.uni-muenchen.de/25968/

Mobarek,A., Keasey,K. (2002). Weak form market efficiency of an emerging market:

Evidence from Dhaka Stock market of Bangladesh. Retrieved from:
https://www.researchgate.net/publication/250141858_Weak-
form_market_efficiency_of_an_emerging_Market_Evidence_from_Dhaka_Stock_Market_of
_Bangladesh1/citations