Efficient Market Hypothesis

History
• The history of EMH can be traced back to random walk
theory.
• Jules Regnault (french Broker) who published a book in 1863,
and then to French mathematician Louis Bachelier whose
Ph.D. dissertation titled "The Theory of Speculation" (1900)
included some remarkable insights about the random walk of
stock prices.
• Research by Alfred Cowles in the 1930s and 1940s suggested
that professional investors were in general unable to
outperform the market; thus supporting the random walk.
• Later on, in 1953, Maurice Kendall, a British Statistician
presented a paper about the behaviour of stock prices
supporting random walk theory. “Kendall suggested that
stock prices follow a random walk, he was implying that the
price changes are independent of one another just as the
gains and losses in our coin-tossing game were independent”
(Myers, 2003, p. 350) – Scatter Diagram on Page 351
 History
• The efficient-market hypothesis was developed by
Professor Eugene Fama at the University of Chicageo
Booth School of Business as an academic concept of
study through his published Ph.D. thesis in the early
1960s at the same school.
• In 1965 Eugene Fama published his dissertation
arguing for the random walk hypothesis
• In 1970 Fama published a review of both the theory
and the evidence for the hypothesis. The paper
extended and refined the theory, included the
definitions for three forms of of market efficiency:
weak, semi-strong and strong.
 Introduction
• The word efficient refers to quick access to all
information. In an efficient market, there are so
many investors or participants and they all have
the similar access to information. Therefore all
these participants of similar investment
ambitions compete with each other in an
efficient market.
• All these investors are willing to get a high rate of
return and they try their best to lower the risk.
But in efficient market, everyone has equal
chance of fair return.
 Types of Efficiency
• In economics, we deal with three kinds of efficiency.
1. Efficiency related to income tax.
2. Efficiency related to delivery of products to the
customers.
3. Efficiency related to the structure of information.
• In efficient market hypothesis, our main focus is on
informational efficiency, which is also known as market
efficiency which says that the price of a given stock
elaborates the net present value for upcoming gains.
 Introduction
• Efficient market hypothesis proposed by Eugene
Fama (1960), an American economist who says
that everything that can be known about a stock
has already been incorporated into the price of
that stock
• According to Fama (1970, p. 383), “A market in
which prices always fully reflect all available
information is called efficient.”
• EMH described a relationship between the stock
prices and information available about the good
news (price gain) or bad news (price decline).
 Introduction
• Any unexpected return from portfolio of stocks is
just a chance and cannot be quantified and
predicted from past information or new event
information.
• With the emergence of efficient market
hypothesis, it was proved that there is a random
walk in the stock prices.
• The study also proved that the stock prices
reflect new information quickly rather than
gradually. But this information brings random
changes in stock prices.
 Types of EMH
• The information may be:
1. Stock market information: It is the information about
the share prices and it presents the data which is
related to the trading volume.
2. Public information It is the information, which is easily
and equally available to entire general public.
3. Non public information: It is the private information,
about which only the firm officers and their close
friends can be aware of price news. Or Inside
information It is the information, about which only the
insiders of stock market are aware.
 Types of Efficiency
• On the basis of available Information:
– Weak form of Efficiency
– Semi-strong form of Efficiency
– Strong form of Efficiency
 Weak form of EMH
• That the current prices of securities and stocks fully
incorporates all available information of past
• No one can “beat” the market by analyzing the past
prices and predicting the future prices based on the
past prices information.
• If the market is efficient in the weak sense, then it is
impossible to make consistently superior profits by
studying past returns. Prices will follow random walk.
 Weak form of EMH
• The investors cannot predict the future share prices by
reviewing past stock prices. In weak form of EMH, the
flow of information occurs slowly and gradually. Here
all the historical data is completely absorbed and there
is no historical record available for general public to
estimate future prices.
• Therefore, historical record is of no use to forecast
future stock prices in weak form of market. Thus the
price changes are random. It shows no correlation
between the beginning and ending price.
 Semi-Strong form of EMH
• The semi-strong-form of market efficiency hypothesis
suggests that the current price fully reflects all publicly
available information.
• Public information includes not only past prices, but
also data reported in a company’s financial
statements; earnings and dividend announcements;
announced merger plans; the financial situation of
company’s competitors; expectations regarding
macroeconomic factors such as inflation,
unemployment.
• The prices will adjust immediately to public
information.
 Strong Form of EMH
• The strong form of EMH states that the
current prices fully incorporate all existing
information, both “public and private”.
Publicly and privately held information or
insider information too, is so rapidly
included by market prices, these
information cannot be used to make surplus
trading earnings.
 Alternative of EMH
• Fundamental analysis and Technical analysis
• Fundamental analysis is a traditional method
of analyzing investments. It evaluates the
quantitative and empirical data. Therefore,
the fundamental analysis was formally used to
analyze and evaluate the balance sheets,
annual reports, trend analysis, profitability
ratios and profit & loss figures in order to beat
the market.
 Alternative of EMH
• Technical analysis on the other hand determines
the fluctuations in share prices moving up or
down. These are also called chartist.
• The fundamental analysis helps in long term
investments while technical analysis is useful for
short term investments. Both of these are good
methods of investment analysis.
• Later on, after 1960’s, some researches provided
evidence against the concept of investment
analysis techniques, i.e., EMH