African Scholar

VOL. 23 NO. 7 Publications &

ISSN: 2276-0732 Research
DECEMBER, 2021 International
African Scholar Journal of Mgt. Science and Entrepreneurship (JMSE-7)

The Efficient Market Hypothesis: A critical review of

Equilibrium Models and Imperical Evidence

Mukhtar Abdullahi
Department of Banking and Finance, Waziri Umaru Federal Polytechnic,
Birnin Kebbi, Kebbi State

Abstract
This paper critically reviews the concept of efficient markets hypothesis (EMH). The
key aim of this study is to explain the informational efficiency of the capital market
as uphold by Professor Eugene Fama. Therefore, attempt was made to review the
empirical study conducted around the globe testing the efficacy of this theory as well
as some of the price equilibrium models were equally reviewed in order to attest this
fact. The study efficiently found that EMH is much relevant theory as empirical
studies conducted by various researchers around the globe confirms the markets
efficiency at weak form of efficient market hypothesis. More so, some of the price
equilibrium models reviewed substantially indicates presents of efficiency element
that explain the fundamentals of the EMH.

Keywords: Efficient markets, Weak form of efficiency, Equilibrium models

Introduction
The main theme of this report is to explain
the intellectual soundness of the efficient
market hypothesis. First the project begins
with a mantra that has been found and
cherished by Fama for the field of finance
that is Market is efficient which being
uphold in the efficient market hypothesis.
The efficient markets theory is one of the
solid propositions in the field of finance
for almost five decades. Additionally,

379 africanscholarpublications@gmail.com
2021
Read, (2013) assert that theoretical foundations of the EMH hinges fundamentally on
three keys tenets. First, market participants are uphold as being rational and supposedly
valued assets rationally in a passive way. Second, the assumption that some market
participants are not considered being rational and their random trading pattern cancel
one another without influencing the market prices. Third, the assumption that upholds
some participants are rational and met with rational arbitrageurs in the market who
eliminate and limited their excess influence on security prices.
The literature review of this report was based on equilibrium models that confirms
element of efficiency in the price mechanism of the markets. Additionally, the report
reviewed the empirical study conducted around the globe confirming efficiency of the
markets as uphold by the Eugene Fama.
This report is sketched with section 1 covering introduction. Section 2 reviews
on EMH orthodoxy, assumptions, norms and myth. While Section 3 presents
the some of the equilibrium models research confirming the informational
efficiency of the EMH. Moreover, section 4 outlined the empirical studies
conducted confirming the efficiency of the markets. Finally the report ended
with elaborate conclusion in section 5.

Efficient Market Theory

The efficient markets theory is one of the solid propositions in the field of
finance for almost five decades. In what appears to be the most classic
hypothesis statement of all time, Fama (1970) asserted that markets that fully
absorbed any available information into securities prices is called an "efficient
market". in simple terms , a market participant whether professional or non-
professional - cannot reliably beat or influenced the market and the number of
resources as well as effort such participants committed in order to select, and
evaluate trading stocks are fruitless (Fama, 2011). It is good to passively
approach the market than engage in active approach that is costly and riskier. In
fact, if the efficient market theory holds, truly the market knows best.
Indeed, the immediate consequence of EMH is that active investors can never
consistently beat or outsmart the market and passive investors can in average
achieve the same return as active investors do. Even though, sometimes asset
prices significantly drift following the aftermath of some key events such as
earnings announcements, however, as time passes over drift becomes weaken
by the action of the arbitrageurs who exploit them (Campbell, 2014). On the
overall, values of the financial markets are always correct and pattern of future

380 africanscholarpublications@gmail.com
2021
prices arbitrarily depend on randomly new information. These apt Fama (1998)
claims that market price does not have a cognitive memory, and thus it could
not be used for predicting upcoming prices. Certainly, future profits are not
engrained to a unique pattern but rather randomly distributed (Burton and Shah,
2013). Therefore, should investors outsmart the markets this could be as a result
of random processes, otherwise why those investors who do not beat the market
at the same time make substantial losses? In a related development, Szyszka
(2008) points out that the fundamental building blocks of EMH is based on
rationality of investors (that is 'homo economicus' concept) as well as on the
strength of arbitrage self-correcting mechanism (that is perfect market notion).
Moreover, three sets of information are identified in the stock markets
according to the Fama’s EMH. First, information linked to historical prices-
referring to the weak form of the market. Second, information classified as
public known information which has to do with semi-strong form of the market.
Third, information referred as private information – a strong notion of the strong
form of the market. The general implication is that a market may be efficient
depends on the particular sets of information.

Equilibrium Models and Markets Efficiency

Testimony of Markets Efficiency Using Equilibrium models and empirical
evidence
Fama (1970) as cited in Jarrow and Larsson (2012) state that market efficiency can
only be tested when joint with some models of equilibrium or popularly known
as "joint hypothesis". In tune with Fama, Lim and Brooks (2009) opined that
testing market efficiency always requires a formal economic model that
precisely defines the term "efficient". That is a model which describes how
information is being manufactured in market prices is required in order to test and
judge whether or not all information available within the market dominion do
reflect in security prices. Moreover, this model to be right for a good testimony
of EMH efficiency must to have properties that seem to qualify the maxim of
EMH notion. For example, "capital asset pricing model" (CAPM) evolve first by
Sharpe (1964), Lintner (1965) and Mossin (1966) as cited in Palan (2004)
asserts that the model hugely relies on the hunches of investors rationality as
well as efficient market with zero based transactional and taxes costs and overall
equal market expectation.
In a similar vein, Verhofen (2014) contend that CAPM suitability in explaining

381 africanscholarpublications@gmail.com
2021
the informational properties in the asset prices is linked to its foundational
assumptions that also tandem with EMH theory. Verhofen reiterated these
assumptions succinctly in a way that seems to explain the rationality market
scenario of the efficient market. First, is about the investors' concerns on
expected return in trade off with a given rate of volatility. Second assumption
is about the investors' consistent beliefs that rewards commensurate perfectly
with given level of risk. Third, the assumption that suggest only systematic market
risk factor exist which is peculiar to all market portfolios. To establish logic to
these assumptions for example, consider asset with no any kind of risk (no
volatility) that is its expected returns does not vary in relation to the market. In
this example, the security beta is zero with the expected return which tally with
"risk-free rate". Moreover, consider a situation where a security that moves in
tandem with market or simply such security is having beta which is one.
Therefore, with this given asset-market correlation, this asset (security) is said to
earns a return exactly the same with the market that is E (ra) = E (rm). Finally,
consider an asset or security with beta more than one- such asset will promise a
high returns more than the market due to high risk exposure. Therefore, putting all
these expected returns in corroborating with market risk this produce the
concept of CAPM equation = E (fl f ) = R f + pi(E(R m }- R f )
(Brealey et al. 2014). That is Rf stand as "risk-free rate" and E (/?m) - Rf ) stand
as "expected excess return" of the entire market portfolio exceeding the "risk-free
rate".
Fundamentally, CAPM assumes that a security is expected usually to produce the
"risk-free rate" in addition to any reward for taking excess risk as given by that
security's beta (Watson and Head, 2013).
Even though, Fama and French "three factors model" evolved in order to remedy
what the two scholars attribute as CAMP deficiency in addressing the factor
of risk adequately, but in Fama (2011) state that CAPM set the pace and solid
precedence about good understanding of risk-expected returns trade off, and
also lead to understanding the dynamics of active managers in the stock markets.
More still, a more useful "fair game" pricing model that reiterate and buttress the
claims of laureate Fama about EMH efficiency is the "random walk model"
(RWM). The testing evidence of the RWM is generally more consistent with the
informational subset of the weak-form of EMH. A weak form of stock market as
its being define in Fama (1970) seminal paper is said to be a market with
negative serial prices correlation. This definition and many features of the

382 africanscholarpublications@gmail.com
2021
"weak-form efficient" stock market are the baseline concept of RWM. Thus,
RWM as define by Malkiel (2012) is the term that denote that studying past
history cannot lead to right direction today and in the future. Linking this term to
the security market, it simply means that any short variation in security prices
cannot be predicted. In other words, RWM implies that sequence of past prices
cannot in any way be used to gain a clue on what likely future price pattern is
going to be (Palan, 2004). Conversely, Mishra and Pradhan (2009) describes
random walk concept in the heart of a RWM theorist is just like a drunkard
footprints with no clear direction. Additionally, Israel and Moskowitz (2012)
state that RWM is the right model that canvasses that pattern of any changes in
prices are homogeneously distributed in such a way that no any forecast can be
made in order to determined future prices simply by using historical prices data
and changes. Fama (1970, 1991 and 2013) and Fama and French (2005) tested
the empirical efficacy of RWM as it links to EMH at weak form within the scope
of economies in both the emerging and developed world. The results of these
findings all agreed that markets are sufficiently and empirically efficient a dictum
which confirms the supremacy of EMH.
Additionally, Martingale model is another yet useful fair game pricing model for
testifying informational pricing efficiency of the EMH. The Martingale evolves
and formulated by Samuelson (1965) cited in Nisar and Hanif (2012a) assert
that the model was developed as an alternative to "random walk model". The
model was meant to test the random sequence of the stock prices. The main focus
of the Martingale model is on returns and preferences (Palan, 2004). Read (2013)
state that the model emphasizes that price patterns do follows sub martingale in
accordance with information pattern. That is to say the model is trying to say
expected returns on security are condition on the information sequence. Thus, if
this condition holds then no market strategy can ever outperform common buy and
hold strategy. The simple idea of this model is the notion that asset prices are the
representation of value of the expected future returns, which tally with the notion
of EMH.
Furthermore, stock market efficiency can be confirmed using the three
informational set of the EMH. For example, in Fama (1970) seminal review
claimed to have carry observational studies to find out empirical evidence of
market efficiency at given three information set of the market. That is at weak,
semi-strong and strong forms. Fama, experimentation on weak form notion of the
EMH employed the use of serial correlation as well as technical trading strategies,

383 africanscholarpublications@gmail.com
2021
and the outcomes of the testing strongly reveals markets are efficient at weak
form. Later Fama (1991) conduct another next round review of weak form
efficiency. This time Fama test the predictability return by using "price earnings
ratio", "book to market ratio", and "dividend -price ratio" as key variables in the
testing process, which yet confirmed the weak-form efficiency of the stock
markets. Test on semi-strong and strong form of market efficiency are renamed
by Fama (1991) as test for "event studies" and "private information"
respectively. In the event study the total performance of a security returns over
periods of time are measures following the announcement of the event - before
and after. This is in order to find out any consistent correlation of abnormal returns
following the announcement of dividends or any kind of event.
Conversely, Jarrow and Larsson (2012) research tested market efficiency of the
weak and semi - strong forms of efficient market using information reduction
techniques. The results of the research indicate that semi-strong market
contains weak-form market by information reduction. However, Jarrow and
Larsson assert that market at semi- strong form does not contain strong form
of efficient market. Thus, concludes that if market is in semi - strong form it
is highly unlikely arbitrage opportunities to be achieved without bearing
excessive cost.

Empirical Studies and Markets Efficiency

Having considered how price equilibrium models underlying assumptions
fitted well in the concept of EMH, as well as the informational set prove of
the EMH efficiency, still stock market efficiency can further be confirms from
the empirical studies conducted by various researchers.
For example, Nisar and Hanif (2012a) evaluates weak form market efficiency
using statistical tools such as "variance ratio test" and "run test" on seven Asia
pacific stock exchanges within the period of 1997 to 2011. The following are
the stock exchanges under this study: Japan's Nikke N225, Korea's Kospi
composite, Pakistan's KSE100, Australia's "All ordinary ASX", Hong
Kong's "Hang seng index HIS", India's BSE SENEX and China's shanghai
composite. The results confirms that "Hang seng Index HIS", Kospi
composite, "All ordinary ASX" and Nikke N225 are weak form efficient
markets. Similarly in a sister research by Nisar and Hanif (2012b) studies
Europe and North American's stock exchanges such as USA's NYSE
composite, Canada's "S&P TSX composite", UK's TTSE 100 Index",

384 africanscholarpublications@gmail.com
2021
Germany's DAX 30, France's CAC 40 and Spain's IBEX 35. The testing
which involves daily, weekly and monthly assessment using "variance ratio
test" and "run test" within the period of 1997 to 2011. The results indicated
that DAX 30, NYSE composite, IBEX 35 and TSX composites are weak form
efficient.

Conclusion
Clearly Fama’s work is an inspiring effort in proving the informational sensitive
of the financial markets which turnout to be more right against being wrong.
Certainly, Fama and allies have done more for investors as compared to any
contemporary economist. Truly, the market hypothesis has become a north –
star for all things in finance. The EMH myth has made investors and all
stakeholders thinking ever more precise. Of course, the EMH impacts have
gone beyond academics. Because it is not so easy to remember what world of
finance was before the EMH. Infact, the Fama view on prediction of utility
maximization are based on the basic instinct of human rationality. The study
has unfolded the testing of the EMH using some of the fair pricing equilibrium
models such as CAPM, RWM and Martingale reveals a unifying theme that
conjectured with the EMH notion. That is all investors are rational and that only
risk alone can determine the extent of their returns making in an efficient market
. Similarly, evidence of EMH efficiency from the various studies conducted by
some of the researchers captured in this study has proven Fama claims on the
EMH efficiency. That is some of the world stock markets exhibit absent of
discernible pattern (non-serial correlation) of stock prices at weak form of the
markets – a confirmation of market efficiency.

Reference
Brealey; R.A., Myers, S.C. and Allen, F. (2014) Principles of Corporate Finance.
Berkshire: McGraw-Hill Education
Burton, E.T. and Shah S.N. (2013) Behavioral Finance: Understanding the Social
Cognitive and Economic Debates. New Jersey: John Wiley and Sons, Inc.,
Campbell, J.Y. (2014) Empirical asset pricing: Eugene Fama, Lars Peter Hansen and Robert
Shiller, Scandinavian Journal of Economics, 116 (3) pp. 593-634
Fama, E.F. (1970) Efficient capital markets: A review of theory and empirical work,
Journal of Finance Vol. 25 (2) pp. 383-417
Fama, E.F. (1991) Efficient capital markets: II". Journal of Finance Vol. XLV1 (5) 1575-
1617
Fama, E.F. (1998) Market efficiency and long-term returns, and behavioral
finance.Journal of Financial Economics, Vol. 49 (3) pp. 283-306

385 africanscholarpublications@gmail.com
2021
Fama, E.F. (2011) My life in finance, Annual Reviews of Financial Economics Vol. 3
pp. 1-15
Fama E.F. and French K.R. (2011) Capital structure choices
Fama E.F. and French K.R. (2011) A five -factor asset pricing model Fama-Miller
Working Paper, University of Chicago, Dartmouth College and NBER
Israel, R. and Moskowitz, T.J. (2012) The role of shorting, firm size, and time on market
anomalies. Chicago Booth Paper, No: 12 (22)
Jarrow, R.A. and Larsson, M. (2012) The meaning of market efficiency. Journal of
Mathematical Finance, vol. 22 (1) pp. 1-30
Lim, K. and Brooks, R. (2009) The evolution of stock market efficiency over time: A survey
of the empirical literature. Journal of Economics Surveys, vol. 25(1)
Mishra, P.K. and Pradhan B.B. (2009) Capital market efficiency and financial
innovation- A perspective analysis. The research network, Vol. 4 (1)
Malkiel, B.G. (2012) A Random Walk Down Wall Street. New York: W.W. Norton and
Company. P 26
Nisar, S. and Hanif, M. (2012a) "Testing market efficiency: Empirical evidence from
developed markets of Asia pacific". Available @SSRN: http://ssrn.com/abstract= 198396
(Accessed on 23rd July, 2014)
Nisar, S. and Hanif, M. (2012b) Testing market efficiency: Empirical evidence from
developed markets of Europe and North America. Available @SSRN:
http://ssrn.com/abstract=1983961 (Accessed on 23 rd July, 2014)
Palan, S. (2004) The Efficient Market Hypothesis and its Validity in Today's Markets. Druck
und Bindung: Books on demand GmbH, Norderstedt Germany
Read, C. (2013) The Efficient Market Hypothesis. New york: Palgrave Macmillan
Szyszka, A. (2008) From the efficient market hypothesis to behavioral finance: How
investor' psychology changes the vision of financial markets. Available @SSRN:
http://ssrn.com/abstract:1266862 (Accessed on 23rd July, 2014)
Verhonfen, M. (2014) Finance. Available @SSRN: http://ssrn.com/abstract=2415741
Social Science Electronic Publishing, fnc all right reserved (Accessed on 23 rd July,
2014)

386 africanscholarpublications@gmail.com
2021