EFFICIENT MARKET HYPOTHESIS

CAPITAL MARKET
Capital Market is a place where buyers and sellers can interact and transact financial securities like shares,
debentures, debt instruments, bonds, derivative instruments like the futures, options, swaps etc.
EFFICIENT CAPITAL MARKET
Any market where new information is incorporated into security prices very quickly is called efficient capital
market.
FEATURES OF EFFICIENT CAPITAL MARKET
(a) The prices of securities reflect all the relevant information.
(b) No individual dominates the market.
(c) Transaction costs do not affect security buying and selling.
(d) Investors are rational and so make rational buying and selling decisions.
(e) There are low, or no, costs of acquiring information.

TYPES OF EFFICIENCY
Operational efficiency – means that transaction costs (i.e. brokerage commission, loan arrangement fee, margins
between interest rates for lending and for borrowing etc.) should be as low as possible in capital market.
Allocational efficiency – means that resources are put to their most highly valued use.
Informational efficiency – means that prices at each moment incorporate all available information about future
values.
How efficient capital markets really are is the subject of intense debate. It will be discussed under Efficient
Markets Hypothesis.
EFFICIENT MARKET HYPOTHESIS (EMH)
EMH was originally developed by Professor Eugene Fama.
According to this markets are efficient when prices reflect all relevant information at any point in time.
All relevant information can be categorized into three distinct sets.
(1) All public information + All private information (only insiders know). From this a subset of this can be drawn
(2) All public information (it includes financial statements data, company announcements, analysts’ reports and
past market data etc.) From this another subset can be drawn
(3) Past market data (it refers to all historical price and trading volume information).
THREE LEVELS OF EFFICIENCY
Now EMH divides the three forms of market efficiency w.r.t these three sets of information mentioned above.
1) Weak from efficiency
2) Semi-Strong form efficiency
3) Strong form efficiency
WEAK FORM EFFICIENCY
It states that current market prices fully reflect all past market data. It means investor cannot predict future price
changes by extrapolating prices or patterns of prices from the past. So technical analysis will not work.

SEMI STRONG FORM EFFICIENCY

It states that current market prices fully reflect all publicly available. It includes past market data which is also
said to be publicly available information. So by definition the market which is semi-strong from is also weak form
efficient. So fundamental analysis will not work.

STRONG FORM EFFICIENCY

It states that current market prices fully reflect all publicly available & private information. . So by definition the
market which is strong form is also semi- strong and weak form efficient. So Insider trading will not work.
However this is not likely because given the prohibition on insider trading in most markets it would be unrealistic
to expect markets to reflect all private information. Evidence suggests that markets are not strong form efficient

DIFFERENCES

Fundamental Analysis and Technical Analysis

Points of Fundamental Analysis Technical Analysis

differences
Definition It is the analysis of business’s financial It is the analysis of forecasting the direction of prices
statements, competitors and market. It also through the study of past market data ( i.e. past prices)
considers overall state of the economy and
factors like ROI, GDP, production, employment,
housing, manufacturing, earnings and
management.
Base Public announcements Past prices
Purpose Forecast the share price Focus on market data and the direction of share prices
Usefulness Identify under/over-priced stocks Identify the exact timing to buy or sell the order
Share Determine the intrinsic value Believes that there is no real share price
valuation
Trend Not done Done
Analysis
Assumptions Not made Made

Returns, risks and profits

In order to assess stock market efficiency we need to check that whether genuine economic trading profits can be
made. This requires us to compute abnormal returns which, in turn, requires an asset pricing model. If abnormal
returns are made then market is not efficient otherwise it is efficient.
Abnormal return will be:
αi = (RP – Rf) − [βi × (RM – Rf)]
where RP is the mean return on your portfolio and RM is the mean return on the market.
If the answer of the above equation is positive then stock gives positive abnormal return and if the answer is
negative then stock gives negative abnormal returns.

Example
A stock has a CAPM β of 0.6 and due to some research you have carried out you believe its future return will be
10%. If the risk-free rate is 2% and the expected return on the market minus the risk-free rate is 20%. Calculate
the abnormal returns and draw conclusion.
Answer
αi = (RP – Rf) − [βi × (RM – Rf)]
αi = (10– 2) − [0.6 × (20)] = -4 %
(or)
αi = Expected/Actual return − CAPM /Target return
αi = Expected/Actual return − [RF + {βi × (RM – Rf)}]
= 10 − [2 + {0.6 × (20)}] = -4 %

The results show that there are abnormal returns. Which means that the stock is overpriced.

The joint hypothesis problem: any test of market efficiency involving the calculation of abnormal profits/returns
is a combined test of two hypotheses, namely:
* the market is (informationally) efficient
* the model used to determine/identify abnormal returns is the true asset pricing model (i.e. the model is fully
accurate)
This is a `problem' because it confounds the interpretation of test results. If the test detects significant abnormal
returns, it could be because the market truly is inefficient, or it could be because the model used is wrong, or
both.

EXAM TYPE QUESTION

(a) Explain clearly the following terms:

i. Weak form efficiency;
ii. Semi-strong form efficiency;
iii. Strong form efficiency.
What are the implications for the market to be informationally efficient to both the investors and companies?

(b) Identify and explain which forms of efficiency are adhered to and/or violated in each of the following
hypothetical situations:
i. Weekly returns appear to be weakly but positively correlated with each other;
ii. The top 10 investment funds in the UK outperformed the UK market by an average of 4% in 2013;
iii. A group of students from the LSE has created a trading rule which appears to outperform the UK market;
iv. Royal Petrol plc has just revealed that it has discovered a new method to turn domestic waste into petrol. Its
share price rose by 5%.
ANSWER

(a)
i. Weak form (prices reflect all past information)

This means that one cannot consistently earn (abnormal) investment returns as a result of studying past patterns
of prices for particular securities. Share prices in a market which are consistent with the weak form should
behave like a `random walk' (i.e. share prices do not follow any particular pattern). The `random walk hypothesis'
suggests that there is no connection between successive share price movements. Early empirical work supports
this view, meaning that capital markets are weak form efficient.

ii. Semi-strong form (prices reflect all publicly available information)

This means that no one can earn abnormal returns based on the study of publicly
available information about the enterprise. If publicly information is not incorporated into security prices then
abnormal returns can be made. For example, information like dividend announcement, profit announcement.
iii. Strong form (prices reflect all public and private information)

This means that no one can obtain abnormal return by private (insider) information. Security prices would have
already incorporated the information content of any valuable private information about a company.
(b)
i. According to our discussion in part a), the weak form of market efficiency appears to be violated.
ii. According to our discussion in part a), assuming that investment fund managers invest based on publicly
available information, the semi-strong form of market efficiency appears to be violated. Assuming that
investment fund managers invest based on private information, the strong form of market efficiency appears to
be violated.
iii. According to our discussion in part a), the weak form of market efficiency appears to be violated.
iv. According to our discussion in part a), the weak form of market efficiency appears to be violated.