M.B.A.

4th Semester
Investment Management
Unit I : Investments

Concept of Investment, Real Vs. Financial assets ; Investment decision process ;

Sources of Investment Information ; Investment Vs. Speculation ; Factors to be
considered in investment decision – Liquidity, Return, Risk, Maturity, Safety, Tax
and Inflation. The concept and measurement of return – realized and expected
return. Ex-ante and ex-post returns. The concept of risk. Sources and types of risk.
Measurement of risk – Range, Standard Deviation and Co-efficient of Variation.
Risk-Return Trade-off. Risk premium and risk aversion. Approaches to investment
analysis – Fundamental analysis, Technical analysis ; Efficient Market Hypothesis.

Meaning and Definition of Investment

Investment may be defined as the purchase of an asset to produce a return. It is the commitment of
funds made in the expectation of a rate of return.

According to F. Amling, “Investment may be defined as the purchase by an individual or

institutional investor of a financial or real asset that produces a return proportional to the risk assumed over
some future investment period”. According to D.E. Fisher and R.J. Jordon, “Investment is a commitment
of funds made in the expectation of some positive rate of return. If the investment is properly undertaken,
the return will be commensurate with the risk the investor assumes”.

Money and information are the basis and the first requirement of investment. Only money is not
enough, as investment are generally made on the basis of information of the companies, instruments,
industry and economy. Both money and information flow to help making investment management.

There are different methods of classifying the investment avenues. A major classification is Physical
Investments and Financial Investments. They are physical or real, if savings are used to acquire physical
assets, useful for consumption or production. Some physical assets like ploughs, tractors or harvestors are
useful in agricultural production. A few useful physical assets like cars, jeeps etc., are useful in business.
Many items of physical assets are not useful for further production of goods or create income as in the case
of consumer durables, gold, silver etc. Among different types of investments, some are marketable and
transferable and others are not. Examples of marketable assets are shares and debentures of public limited
companies, particularly the listed companies on Stock Exchanges, bonds of P.S.U., Government
Securities etc. Non-marketable securities or investments in bank deposits, provident fund and pension
funds, insurance certificates, post office deposits, national savings certificate, company deposits, private
limited companies shares etc.
Many types of investment media or channels for making investments are available. Securities
ranging from risk free instruments to highly speculative shares and debentures are available for alternative
investments. All investments are risky, as the investor parts with his money. An efficient investor with
proper training, can reduce the risk and maximize returns. He can avoid pitfalls and protect his interests.

Any investor would like to know the media or range of investments so that he can use his discretion
and save in those investments which will give him both security and stable return. The ultimate objective of
the investor is to derive a variety of investments that meet his preference for risk and expected return. The
investor will select the portfolio which will maximize his utility. Another important consideration is the
temperament and psychology of the investor. It is not only the construction of a portfolio that will promise
the highest expected return, but it is the satisfaction of the need of the investor.
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Investment will generally be used in its financial sense and as such investment is the allocation of
monetary resources to assets that are expected to yield some gain or positive return over a given period of
time. Investment is a commitment of a person’s funds to derive future income in the form of interest,
dividends, rent, premiums, pension benefits or the appreciation of the value of his principal capital.

The investors and market analysts depend on the timely and correct information for making
investment decisions. In the absence of such information, their decisions will depend on hearsay and
hunches. In order to enable the correct investment decisions to be made, investment need to know the
sources of information. In the fast expansion of markets and increasing complexity of economies, the
amount of the information is also fast growing. The collection of information and its analysis is time
consuming and expensive. Besides, analysis of the information also requires expertise which all investors
may not have. The available books on the subject deal with the theoretical aspects and not much practical
analysis and down to earth operational aspects. As such the investors are left to make decisions by hunches
and intuition and not on scientific analysis of the data. Those who have better information use it to make
extra mileage on such information. It is also possible that insiders who have the information before it
becomes public take advantage of it called Insider Trading.

Investment Alternatives
A wide range of investment alternatives are available for investors. They fall into two broad
categories, viz., financial assets and real assets.

Financial Assets
Financial assets are paper (or electronic) claims on some issuer such as the government or a
corporate body. The important financial assets are equity shares, corporate debentures, government
securities, deposit with banks, mutual fund shares, insurance policies and derivative instruments. As the
economy advances, the relative importance of financial assets tends to increase.

Real Assets
Unlike financial assets, real assets are tangible or physical in nature. Real assets are represented by
tangible assets like residential house, commercial property, agricultural farm, gold, precious stones and
art objects. As the economy advances, the relative importance of financial assets tends to increase. The
major types of real assets are as follows :

A. Real Estate
• Residential house
• Commercial property
• Urban and semi-urban land
• Agricultural farm
B. Precious Metals
• Gold
• Silver
C. Precious Stones
• Diamonds
• Others
D. Art Objects and Collectibles
• Paintings
• Sculptures
• Antiques
• Others
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Investment Process
The investment process may be described in the following stages :

1. Investment Policy : The first stage determines and involves personal financial affairs and
objectives before making investment. It may also be called the preparation of investment
policy stage. The investor has to see that he should be able to create an emergency fund, an
element of liquidity and quick convertibility of securities into cash. This stage may, therefore, be
called the proper time for identifying investment assets and considering the various features of
investments.

2. Investment Analysis : After arranging a logical order of types of investment preferred, the
next step is to analyse the securities available for investment. The investor must make a
comparative analysis of type of industry, kind of securities etc. The primary concerns at this
stage would be to form beliefs regarding future behaviour of prices and stocks, the expected
return and associated risks.

3. Investment Valuation : Investment value, in general, is taken to be the present worth to

the owners of future benefits from investments. The investor has to bear in mind the value of
these investments. An appropriate set of weights have to be applied with the use of
forecasted benefits to estimate the value of the investment assets such as stocks, debentures
and bonds and other assets. Comparison of the value with the current market price of the asset
allows a determination of the relative attractiveness of the asset. Each asset must be valued on its
individual merit.

4. Portfolio Construction and Feed-back : Portfolio construction requires a

knowledge of the different aspects of securities in relation to safety and growth of principal,
liquidity of assets etc. In this stage, we study, determination of diversification level,
consideration of investment timing, selection of investment assets, allocation of investible
wealth to different investments, evaluation of portfolio for feed-back.

Speculation
Investment and speculation are somewhat different and yet similar because speculation requires an
investment and investments are at least somewhat speculative. Investment usually involves putting money
into an asset which is not necessarily marketable in the short run in order to enjoy a series of returns the
investment is expected to yield. On the other hand, speculation is usually a more short-run phenomenon.
Speculation tend to buy assets with the expectation that a profit can be earned from a subsequent price
change and sale. Accordingly, they buy marketable assets which they do not plan to own for very long.

Probably the best way to make a distinction between investment and speculation is by considering
the role of expectations. Investments are usually made with the expectation that a certain stream of income
or a certain price which has existed will not change in the future. Speculations, on the other hand, are
usually based on the expectation that some change will occur. An expected change is a basis for speculation
but not for an investment.

Speculation involves a higher level of risk and a more uncertain expectation of returns but in many
cases the investors are also in the same boat. The investor who thinks that the market fluctuations of his
investments are not of interest to him because he is buying solely for income can very well be compared
with the ostrich burying its head in the ground during danger and feeling himself secure.
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An investor constantly evaluates the worth of a security whereas the speculator is interested in
market action and price movements.

Investment Vs. Speculation

Investment differs from speculation in the following ways :

1. Investment usually involves putting money into an asset to enjoy a series of returns on it.
Speculation tends to buy asset with the expectation of profit on sale due to its price change.

2. The assets need not necessarily be marketable for investor. Speculators typically buy marketable
assets.

3. The length of commitment is comparatively long term in investment. Speculation is always a

short term holding for ‘quick time’ trading.

4. Investment is considered to involve limited risk. Speculation is considered as an involvement of

funds of high risk.

5. The purpose of investment is to receive a stable return over a period of time. Buying low and
selling high making a large capital gain is associated with speculation.

6. The psychological attitude of an investor is cautious and conservative and of a speculator daring
and careless.

The investors and market analysts depend on the timely and correct information for making investment
decisions. In the absence of information, their decisions will depend on hearsay and hunches. In order to
enable the correct investment decisions to be made, investment need to know the sources of information. In
the fast expansion of markets and increasing complexity of economies, the amount of the information is
also fast growing. The collection of information and its analysis is time consuming and expensive. Besides,
analysis of the information also requires expertise which all investors may not have. The available books of
the subject deal with the theoretical aspects and not much practical analysis and down to earth operational
aspects. As such the investors are left to make decisions by hunches and intuition and not on scientific
analysis of the data. Those who have better information use it to make extra mileage on such information.
It is also possible that insiders who have the information before it becomes public take advantage of it called
Insider Trading.

Factors to be considered in Investment Decisions

The investor has various alternative avenues of investment for his savings to flow in accordance with
his preferences. Savings flow into investment for a return, but savings kept as cash are barren and do not
earn anything. Savings are invested in assets depending on their risk and return characteristics. But a
minimum amount of cash is always kept in hand for transactions and contingencies. Any rational investor
knows that money is losing its value by the extent of the rise in prices. If money lent cannot earn as much as
rise in prices or inflation, the real rate of return is negative. All investments involve some risk or
uncertainty. The objective of the investor is to minimize the risk involved in investment and maximize the
return. The following factors are to be considered in investment decisions.
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1. Risk : The risk depends on the following factors :

(a) The longer the maturity period, the larger is the risk. Thus, deposits of two years carry a
higher rate than the one year deposits.

(b) The more the creditworthiness of the borrower or agency issuing securities, the less is the
risk. Thus, the risk of loss of interest and principal is less with the Government or semi-
government bodies than with the private corporate units.

(c) The nature of instrument, namely, the debt instrument or fixed deposit or ownership
instrument like equity or preference share, also determines risk. The risk of loss
of money is less in the case of debt instruments like debentures, as these are
secured and fixed interest is payable on them. In the case of ownership instruments, the
risk more due to their unsecured nature and variability their return and ownership
character.

(d) The risk of variability of returns is more in the case of ownership capital as the return varies
with the net profits after all commitments are met. As such, equity and preference shares
of companies are more risky than `debentures and bonds.
(e) The nature of tax liability on the instruments – the tax provisions would influence the return
as the net effective return for a tax payer would be higher for tax free instruments as in
the case of NSE, NSS. Thus, tax implications of investment are an important factor in
considering the return on investment.

2. Return : A major factor influencing the pattern of investment is its return, which is the income
plus capital appreciation, if any. The difference between the purchase price and the sale
price is capital appreciation and the yield is the interest or dividend, divided by its purchase price.

3. Safety : The safety of capital is the certainty of return on capital without loss of money or time
involved. In all cases of money lent, some transaction costs and time are involved in getting the
funds back. But leaving aside such general costs like stamp duty, postal charges etc., the time
involved is also an important factor. Thus, if safety of capital is to be assured, then riskless
return as in the case of Government bonds is to be chosen. If the return is higher, as in the case
of private securities, then the degree of safety is less.

4. Liquidity : If a capital asset is easily realizable, saleable or marketable, then it is said to be

liquid. If an investment can be encashed with a time lag as in the case of equity shares or with loss
of money as in the case of corporate deposits, then they are less liquid. If, on the other hand,
there is a good market for the capital asset and no risk of loss of money or capital and no uncertainty
of time involved, then the liquidity of the asset is good. If the liquidity is high, then the
return may be low as in the case of bank saving deposits or MF units.

5. Marketability : This refers to transferability or saleability of an asset. Those listed on a stock

market are more easily marketable than those that are not listed. Public limited companies will
have their shares more easily transferable than those of private limited companies.

An investor generally prefers liquidity for his investments, safety of his funds, a good return with a
minimum risk or minimization of risk and maximization of return.
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Sources of Information
The following are the different sources from which information can be obtained.

1. World Affairs : The day-to-day developments abroad are published in Financial Journals like
Economic Times, Financial Express, Business Line etc. Some foreign journals like London
Economist, Far East Economic Review and Indian Journals like Business India, Fortune India etc.,
also contain developments of economic and financial nature in India and abroad. IMF News
Survey, World Bank and IMF Quarterly Journals, News Letters of Foreign Banks like those of
Grindlays, Standard etc., contain all the needed information on world developments.

2. National Economic Affairs : The daily newspapers particularly financial papers referred to
above contain all the national information. Besides Journals like Economic and Political Weekly,
Business India, Dataline Business, Business Today, Fortune India contain the material on
economic developments. RBI’s Annual Reports, Reports on currency and finance and monthly
reports etc., all contain a wealth of information on the economy and the currency. The reports of
planning commission and annual reports of various ministries also contain a lots of
information.

3. Industry Information : There are various Associations like Chambers of Commerce, Merchants
Chamber and other agencies who publish industry data. The reports of Planning Commission,
Government of India, Publications from Industry and Commerce Ministries also contain a lot of
information. Directory of Information published by the BSE also contain information on industries
and companies and this is undated from time to time. Many daily Financial Papers bring out
regularly studies on various industries and their prospects.

4. Company Information : The information on various companies listed on Stock Exchange is

readily available in daily financial papers. Besides the Fortnightly Journals of Capital Market, Dalal
Street, Business India contain a lot of information on the industries and companies, listed on stock
exchange. Results on equity and market research are also published in these journals. As referred
earlier, the BSE publishes directory of information on Industries and Companies, which are listed
on stock exchanges and the journals of capital market and dalal street also publish these data.
Computer software on these data are also available with a number of software companies. The
BSE also publishes weekly reviews, monthly reviews giving data on various aspects of listed
companies.

5. Security Market Information : A number of big brokers firms who have equity research are
sending newsletters on Market Information with Fundamental and Technical Analysis, combined in
those reports. The Capital Market, Dalal Street, Business India and few other Stock Market
Journals like Fortune India, Investment Week etc., contain the information on securities markets.
The ICFAI also publishes a monthly Journal called Chartered Financial Analyst, which contain
economic data, company information, market information, security analysis, beta factors and a
host of other items, useful for security analysis. The data on trade cycles and settlements,
records dates, book closures etc.., are contained in financial papers like Economic times, Business
Line, Financial Express etc., after they are released by stock exchanges and companies.
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6. Security Price Quotations : The daily quotations on various stock exchanges, OTCEI, NSE are
published in the daily newspapers. Each stock exchange is publishing its own daily quotations list,
giving out opening, high, low and closing quotations of all traded securities. They also publish
volume of trade for individual securities and also the total for all securities traded on a daily
basis, in terms of shares and value of trade. The Price Indices, for all securities, industry-wise,
region-wise etc., are published by the RBI. BSE and major stock exchanges, in the country.
Besides, each financial daily has its own indices published in its paper.

7. Data on Related Markets : Data on Money Market, Government Securities Market are
available in the publication of RBI and DFHI, Indian Bank Association, Securities Trading
Corporation and Banks. These data are published on a daily basis on the financial dailies and
journals. The publications who deal with these markets are however fewer in number compared
to those on stock and capital markets. The information on Forex market is available in RBI
publications, Foreign Exchange Dealers Association and foreign banks.

8. Data on Mutual Funds, UTI etc. : These are published in the daily financial papers – atleast
once in a week in the Investment Weekly or Investors Guide. Capital Market, Dalal Street and
Business India also contain information on Mutual Funds.

The Concept and Measurement of Return

Return is the ultimate objective of any investment program. It is the benefit associated with an
investment. We invest money so that we get a return on it. An investor pays Rs. 100 to buy a debenture
on which interest of Rs. 10 is received at the end of the year. After receiving the interest the investor sells
the debenture for Rs. 105. The total return on the investment is 15 / 100 * 100 = 15 %. It consists of
capital appreciation plus dividend or interest.

The computation of return is critical to portfolio selection because it is one of the parameters by
which the investors decide to choose one security over another. Return is the benefit associated with an
investment. But the term return can mean different things depending on the method of computation. It can
be single period return or multi-period return. In single period return, it can be ex-post return or ex-ante
return. If the return is to be computed for more than one period, it can be calculated as the arithmetic
average return or the geometric mean rate of return. In each of the above cases, the computed value will be
different. Hence the investor must be clear about what return is to be calculated, and how it was calculated.

Types of Return

There are several types of return based upon the period for which it is calculated and the method of
calculation.

Single Period Return : Single period return is calculated only for one period. If the return is being
computed for a security in the past period it is called ex-post return. If the return is being computed for a
security in the future period it is called ex-ante return.

Ex-Post Return : It is the return calculated over a past period. If the initial investment in a debenture was
Rs. 1,000 on January 1, 2000, and at the end of the year, the investor received Rs. 100 as interest
income, and sold the debenture for Rs. 1,100, then his ex-post return is computed as :
Ex-post return = 200 / 1,000 * 100 = 20 %.
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Ex-Ante Return : It is the return calculated for a future period. When the investor wants to know what
return he can get on his investment in the next period, he does not know for certain that he will get that
return. Therefore, he has to assign probabilities to the return. Ex-ante return is also called expected return
because it is the return the investor expects to receive.

The Concept of Risk

Risk is the common denominator in virtually all financial decisions. Investors deciding which
securities to purchase, marketing managers deciding whether to launch a new product, plant managers
deciding on the installation of a new production line, and financial executives deciding how to finance the
firm’s operations and investments all face choices that involve uncertain future cash flows. Evaluating
these risks and factoring them into decisions are thus essential aspects of financial decision making. The
objective is not to avoid risk – that is impossible – but to recognize its existence and to ensure that expected
compensation is adequate for the risk.

Perhaps the most important development in finance in the past 40 years is the ability to quantify the
risk. The ability to measure risk has led, in turn, to new theoretical and empirical work relating risk and
return. The result has been a vastly improved understanding of the way that risky assets are valued in a
competitive market.

Risk is defined as the ‘variability of return around the expected average’.

Sources and Types of Risks

Risk emanates from several sources. The three major sources of risks are : business risk, interest
rate risk and market risk.

Business Risk : This risk arises due to poor business performance. This may be caused by variety of
factors like competition, new technologies, development of substitute products, shifts in consumer
preferences, inadequate supply of essential inputs, changes in government policies and so on. The poor
business performance definitely affects the interest of equity shareholders, who have a residual claim on the
income and wealth of the firm. It can also affect the interest of debenture holders if the ability of the firm to
meet its interest and payment obligation is impaired.

Interest Rate Risk : The changes in the interest rate have a bearing on the welfare of investors. As
the interest rate goes up, the market prices of existing fixed income securities fall, and vice versa. This
happens because the buyer of a fixed income security would not buy it at its par value or face value if its
fixed interest rate is lower than the prevailing interest rate on a similar security. While changes in interest
rate have a direct bearing on the prices of fixed income securities, they affect equity prices too.

Market Risk : Even if the earning power of the corporate sector and the interest rate structure remain
more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate. While there can
be several reasons for this fluctuation, a major cause appears to be the changing sentiment of the investors.
There are periods when investors become bullish and their investment horizons lengthen. Investors
optimism, which may border on euphoria during such periods, drives share prices to great heights. On the
other hand, when a wave of pessimism sweeps the market, investors turn bearish. Prices of almost all
equity shares register decline as fear and uncertainty pervade the market. The market tends to move in
cycles. The cycles are caused by mass psychology.
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Types of Risk

Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows :
Total Risk = Unique Risk + Market Risk

The unique risk of a security represents that portion of its total risk which stems from firm-specific factors
like the development of a new product, a labour strike, or the emergence of a new competitor. Events of
this nature primarily affect the specific firm and not all firms in general. Hence, the unique risk of a stock
can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different
stocks tend to cancel each other – a favourable development in one firm may offset an adverse happening in
another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.

The market risk of a security represents that portion of its risk which is attributable to economy-wide
factors like the growth rate of GDP, the level of government spending, money supply, interest rate
structure and inflation rate. Since these factors affects all firms to a greater or lesser degree, investors
cannot avoid the risk arising from them. Hence, it is also referred to as systematic risk or non-diversifiable
risk.

Measurement of Risk
Risk refers to the possibility that the actual outcome of an investment will differ from the expected
outcome. Put differently, risk refers to variability or dispersion. If an assets return has no variability, it is
riskless. Suppose you are analyzing the total return of an equity stock over a period of time. Apart from
knowing the mean return, you would also like to know about the variability in returns.

Variance and Standard Deviation : The most commonly used measure of risk in finance is variance or its
square root, the standard deviation. The variance and the standard deviation of a historical return series are
defined as follows :

Standard deviation is commonly employed in finance as a measure of risk.

Risk Premium
Investors assume risk so that they are rewarded in the form of higher return. Hence risk premium
may be defined as the additional return investors expect to get, or investors earned in the past, for assuming
additional risk. Risk premium may be calculated between two classes of securities that differ in their risk
level.

Risk-Return Trade-off

All investments have some risks. Investment in shares of companies has its own risks or uncertainty.
These risks arise out of variability of returns or yields and uncertainty of appreciation or depreciation of
share prices, loss of liquidity etc. The risk over time can be represented by the variance of the returns,
while the return over time is capital appreciation plus payout, divided by the purchase price of the share.

Normally, the higher the risk that the investor takes, the higher is the return. There is, however, a
riskless return on capital of about 10 % , which is the bank rate charged by the RBI or long term yield on
Government securities at around 11 % to 15 %. This riskless return refers to lack of variability of return
and no uncertainty in the repayment of capital. But other risks such as loss of liquidity due to parting with
money etc., may, however, remain but are rewarded by the total return on the capital.
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Risk-return is subject to variation and the objective of the portfolio manager is to reduce that
variability and thus reduce the risk by choosing an appropriate portfolio.

Fundamental Analysis
Fundamental analysis is based on the premise that the price of a share is based on the benefits the
holders of the share expect to receive in the future in the form of dividends. The present value of future
dividends, computed at an appropriate discount rate to reflect the riskiness of the share, is called the
intrinsic or fundamental value of the share. A share that is quoting below the fundamental value should be
bought, while a share that is priced above the fundamental value should be sold. The fundamental analyst
therefore attempt to find such under or over priced shares for their investment decisions. They believe that

though in the short run, market price may deviate from the fundamental or intrinsic value, in the long run,
the price would reflect the fundamental value. Since dividends distributed by a firm depend on the earnings
of the firm, forecasting future dividends necessarily requires analyzing the economic factors that influence
the financial performance of the firm.

The fundamental believe that the stock prices are reflections of the intrinsic value of common stock.
They developed models based on earnings, dividends, investment opportunities and discounted cash flows.
They believe that the stock price levels and movements can be explained and predicted in terms of the
expectations of the investors in regard to future dividends, earnings, growth rates and investment
opportunities. Their relationships and price are explained in terms of models.

Technical Analysis
Technical analysis is the examination of past price movements to forecast future price movements.
Technical analysis are some times referred to as chartists because they rely almost exclusively on charts for
their analysis. Technical analysis is applicable to stocks, commodities, futures or any tradable instruments
where price is influenced by the forces of supply and demand. Technical analysts consider the market to be
80 % psychological and 20 % logical. Fundamental analysts consider the market to be 20 %
psychological and 80 % logical.

Technical analysis involves a study of market generated data like prices and volumes to determine
the future direction of price movements. The basic premises underlying technical analysis are as follows :

• Market prices are determined by the interaction of supply and demand forces.
• Supply and demand are influenced by a variety of factors, both rational and irrational. These
include fundamental factors as well as psychological factors.
• Barring minor deviations, stock prices tend to move in fairly persistent trends.
• Shifts in demand and supply bring about changes in trends.
• Irrespective of why they occur, shifts in demand and supply can be detected with the help of charts
of market action.
• Because of persistence of trends and patterns, analysis of past market data can be used to predict
future price behaviour.

A technical analyst is a particular kind of security analyst who prefers not to work through the
infinite number of fundamental facts about issuing corporation, such as earnings of a company and its
competitive products or about forthcoming legislation which may affect the firm. Instead, technical analyst
search for a quick and easy summary of these innumerable fundamental facts by studying the way that the
market price of a security behaves. Over the past decades, technical analysts almost totally focused their
attention on charts of security trading. That is, technical analyst prepares and studies charts of various
financial variables in order to make forecasts about security prices.
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Efficient Market Hypothesis (EMH)

Market efficiency implies that all known information is immediately discounted by all investors and
reflected in share prices in the stock market. As such, no one has an information edge. In an ideal efficient
market, every one knows all possible-to-know information simultaneously, interprets it similarly and
behaves rationally. But, human beings what they are, this of course rarely happens.

In an efficient market, all the relevant information is reflected in the current stock price.
Information cannot be used to obtain excess return, the information has already been taken into account and
absorbed in the prices. In other words, all prices are correctly stated and there are no bargains in the stock
market. James H. Lorie explained what is meant by efficient security market in these words :

“Efficiency in this context means the ability of the capital markets to function so that prices of
securities react to new information. Such efficiency will produce prices that are appropriate in terms of
current knowledge and investors will be less likely to make unwise investments. A corollary is that
investors will also be less likely to discover great bargains and thereby earn extraordinary high rates of
return”.

The requirements for a securities market to be efficient market are :

1. Prices must be efficient so that new inventions and better products will cause a firm’s securities
prices to rise and motivate investors to supply capital to the firm.

2. Information must be discussed freely and quickly across the nations so all investors can react to
new information.

3. Transactions costs such as sales commissions on securities are ignored.

4. Taxes are assumed to have no noticeable effect on investment policy.

5. Every investor is allowed to borrow or lend at the same rate, and finally,

6. Investors must be rational and able to recognize efficient assets and that they will want to invest
money where it is needed most.

Forms of Efficient Market Hypothesis

Tests of the market efficiency are essentially tests of whether the three general types of information –
past prices, other public information and inside information – can be used to make above average returns
on investments.

In an efficient market, it is impossible to make above-average return regardless of the information

available, unless abnormal risk is taken. Moreover, no investor or group of investors can consistently
outperform other investors in such a market. These tests of market efficiency have also been termed as
weak-form (price information) , semi-strong (other public information) and strong form (inside
information).

Fama distinguished three versions of market efficiency – the weak form of efficiency, semi-strong
form of efficiency and strong form of efficiency.
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Weakly Efficient Market : It is a market in which past prices do not provide insight into future
prices. The short term trader cannot earn a return above what could be attained with a naïve buy-and-hold
strategy. In this case, it is assumed that security price already reflect historical prices and trading volume.
Thus, if the random walk hypothesis is empirically confirmed, we may assert that the stock market is weak-
form efficient. In this case, any work done by chartists based on past price patterns is worthless. This is the
oldest statement of the hypothesis which means that the market is weakly efficient. A major assertion of the
weak form of Efficient Market Hypothesis is that successive prices are independent and past prices cannot
be used to predict future prices successfully.

The Semi-Strong form of EMH : The semi-strong form of the efficient market hypothesis
centres on how rapidly and efficiently market prices adjust to new publicly available information including
corporate data such as changes in earnings, dividends, capital structure, sales etc. This form of EMH
postulates that the market absorbs quickly and efficiently not only the price information but all publicly
available information. Examples of this public information are found in the Financial Reports, Balance
Sheets and Profit and Loss Accounts, Earnings and Dividend Reports, financial results etc. In addition
to financial data, any material information affecting the financial position, such as financial structure,
liquidity, solvency etc., is also found relevant and absorbed by the market in the price formation.

Thus, the semi-strong form is empirically not well supported, but in many foreign markets, the
semi-strong form is found to be applicable and markets quickly absorb all published information. This is
possible in those markets due to strict law enforcement, by the market authorities, instantaneous display of
all market information through electronic media and investor awareness of their impact and their quick
absorption of the data. The revolution in informatics and communication technology has made it possible
for the application of the semi-strong form of the EMH to these markets in developed countries.

The Strong form of EMH : Under this hypothesis, markets are so perfect that all information
including private information, insider information and unpublished data, affecting the market are absorbed
in the stock prices. Any investor can then gain the same average returns, whenever he enters the market.
The information of all types is flashed to all investors simultaneously and all players have the same
information at the same time. This means that only superior analysis and interpretation can give better
market returns. This is possible for inside traders, floor brokers and institutional investors who have highly

efficient market research component. Studies made in developed markets have showed that strong form of
efficient market does not exist there also. Investors have not shown consistently higher returns even with all
the information available to them.

Assumptions : For the capital market efficiency theory to operate, the following assumptions are made :
1. Information is free and quick to flow.
2. All investors have the same access to information.
3. Transaction costs, taxes and any bottlenecks are not there and not hampering the free forces of
market.
4. Investors are rational and behave in a cost effective competitive manner for optimization of
returns.
5. Every investor has access to lending and borrowing at the same rate.

6. Market prices are not sticky and absorbs the market information quickly and the market responds
to new technology, new trends, changes in tastes, habits of consumers etc., efficiently and
quickly.