Economics
Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) asserts that financial markets reflect all available information, making it impossible to consistently outperform the market through stock picking or market timing. It suggests that asset prices already incorporate all relevant information, making it difficult for investors to gain an edge. EMH comes in three forms: weak, semi-strong, and strong, each representing different levels of market efficiency.
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12 Key excerpts on "Efficient Market Hypothesis"
eBook - ePub- Christian Szylar(Author)
- 2013(Publication Date)
- Wiley(Publisher)
Observers of the random walk in share prices naturally sought to explain their findings in terms of the efficiency with which new information was incorporated into prices. They reasoned that if there were delays as new relevant information became disseminated through the market, the price of the affect share would not move instantaneously to the new equilibrium level reflecting the information, but would trend toward the new level over time. This might happen gradually or quite rapidly, but would still not be instantaneous. If this were the case, then there would be periods (immediately following the release of new information) when price trends could be discerned. This in turn would mean that excess returns could be made, by either (a) buying the shares before the price had finished moving up to the new equilibrium level justified by good news or (b) selling before the price had finished moving down to the new equilibrium level justified by bad news. The fact that these early studies found no such trends or correlations was seen as powerful support for the argument that the markets were efficient. It seemed to be the case that at any point in time, all available information was reflected in the price; the next move could not be predicted from the last one, because the next piece of news would not be genuine news if it was already implied in past prices. This finding was the central feature of what became known as the Efficient Markets Hypothesis (EMH)—the theory that the major stock markets, in particular those of the USA and UK, while not perfect, are at least efficient.2.2 The Efficient Market Hypothesis
In George Gibson's book The Stock Markets of London, Paris, and New York, published in 1899, we find one of the first references to the question of market efficiency. He writes, “in an open market, when the shares become publically know, the value they obtain may be considered to reflect the most intelligent appreciation possible.”The Efficient Market Hypothesis (EMH) was first formally proposed in University of Chicago professor Eugene Fama's 1970 paper “Efficient Capital Markets: A Review of Theory and Empirical Work.” In a series of publications, Eugene Fama became the father of market efficiency. To beat the market, stock pickers need to discover mispricings in stocks, but the EMH claims that the market is a ruthless mechanism acting instantly to arbitrage away such opportunities, claiming that the current price of a stock is always the most accurate estimate of its value (known as “informational efficiency”).The EMH has evolved into a concept that a stock price reflects all available information in the market, making it impossible to have an edge. There are no undervalued stocks, it is argued, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky
eBook - ePub- R. Stafford Johnson(Author)
- 2014(Publication Date)
- Bloomberg Press(Publisher)
CHAPTER 15 Efficient MarketsIntroduction
One of the most influential theories to emerge out of the finance literature over the last 50 years is the Efficient Market Hypothesis (EMH). Introduced by Burton Malkiel in the 1960s, the EMH precipitated a considerable amount of controversy between proponents of the EMH (primarily academicians) and practitioners who employed fundamental and technical analysis. EMH proponents argued that if the market consisted of a sufficient number of fundamentalists, then their actions would force the market price of a security to its equilibrium value. For example, if a security was underpriced, the fundamentalists would try to buy the security, pushing its market price toward its equilibrium value. In contrast, if a security was overpriced, the fundamentalists would short or sell it, pushing its market price down to its equilibrium value. Thus, according to the proponents of the EMH, with enough fundamentalists, the market price of a security is equal to its equilibrium price. Similarly, EMH proponents argued that if the market consisted of enough technicians, then their actions would eliminate the possibility of earning any abnormal return from identifying trends in security prices. As we noted in the last chapter, if a stock traded low on Monday and high on Friday, then technicians would detect this trend and would buy on Monday and sell on Friday. These actions would augment the price of the stock on Monday and lower it on Friday, thereby eliminating the trend and the possibility of earning an excess profit. If the EMH holds, in the sense that the market consists of a sufficient number of fundamentalists and technicians, then investors would be unable to earn abnormal returns from either fundamental or technical strategies. Thus, the EMH questioned the usefulness of fundamental and technical analysis. In their defense, fundamentalists and technicians argued that the efficient market theory was an oversimplification of how the market functions and that EMH proponents were naive.
- Paul Barnes(Author)
- 2016(Publication Date)
- Gower(Publisher)
CHAPTER 3The Efficient Capital Markets HypothesisIt is often said (but usually only by economists) that whilst individuals may not act rationally some of the time, most people do most of the time. If we wished to forecast what most people would do in a situation, it would simply be a matter of establishing what a rational person would do. Hence, the market price which represents the collective view of investors, and in particular experts, is said to be ‘rational’ and what is known as the Efficient Capital Markets Hypothesis (ECMH), the subject of this chapter, is a part of ‘rational economics’. See the Appendix in this chapter for a mathematical definition of the ECMH.The theory
The idea that the stock market is informationally efficient and that this leads to allocative efficiency is probably an old one. However, it was not until the early 1960s that the full implications of stock market efficiency were studied. These were brought together in 1970 by Eugene Fama who defined the hypothesis that ‘security prices fully reflect all available information’ (1970, p. 383) together with a number of subhypotheses. Fama said that there were three forms of stock market efficiency: weak, semi-strong and strong.THE WEAK FORM
This states that as all new information about the company is immediately and fully reflected in and by a new price movement. As we are unable to forecast new news, and past news is fully impounded in an existing share price, it follows it is not possible to predict new share movements from old share price movements. It also follows that the movement in a share price on one day is not correlated with the share price change the following day. This is often referred to as a ‘random walk’. The principal implication of this is that an investor cannot use past share price movements to predict new price movements in an attempt to earn ‘abnormal returns’. (Abnormal returns are defined as the earning of a higher return on a stock or portfolio than that which is on average earned by the market as a whole. Here and elsewhere, ‘return’ includes both the dividends received during the period plus the increase in the share price as defined in Chapter 2
eBook - ePub- Stefano Fiorenzani, Samuele Ravelli, Enrico Edoli(Authors)
- 2011(Publication Date)
- Wiley(Publisher)
Chapter 1 Energy Markets as Efficient Markets 1.1 The “Efficient Market Hypothesis”Are energy markets efficient markets? In what sense can a commodity market be considered efficient? And what are the trading implications of market efficiency? These are the questions we would like to answer in this introductory chapter. The third question, in particular, has a strong impact on the overall meaning of the book, but obviously, before discussing the trading implications of market efficiency we need to define the concept formally and to try to understand if energy markets can be considered efficient in some sense.The theoretical origins of the Efficient Markets Hypothesis (EMH) are connected with pioneering studies of modern financial economics. The first formal definition and in depth analysis must surely refer to the studies of Roberts (1967) and Fama (1970). Whenever we say that a market, a financial market particularly, is efficient we basically refer to efficiency in the informational sense. In fact, in a competitive market, asset prices dynamically reflect relevant information flows and consequently a certain market is more informationally efficient if it is able to reflect more relevant information in its asset prices. Information is thus relevant if it can predict future price dynamics. According to Fama's original definition, a capital market is said to be efficient with respect to a certain information set if security prices would be unaffected by revealing that information to all market participants. Hence, the description of the information set is the base for the definition of market efficiency.The classic taxonomy of the information set exposed by Roberts (1967) characterizes three different forms of market efficiency: weak, semistrong and strong.In weak form market efficiency the information set considered includes only the history of prices themselves. If the market we are considering is efficient in the weak form, revealing the whole history of security prices to market participants wouldn't impact their behaviour in the market. In other words, future prices cannot be predicted by analyzing prices from the past. Under this framework, price realizations are time independent of each other. Knowing last price realization or the whole history of prices wouldn't change the ability to predict future prices. This form of market efficiency has strong mathematical and trading implications and will be discussed throughout the chapter.
eBook - ePubThe Long and the Short of It
A guide to finance and investment for normally intelligent people who aren't in the industry
- John Kay(Author)
- 2016(Publication Date)
- Profile Books(Publisher)
You regularly hear statements like these in popular discussion. The weak form of the Efficient Market Hypothesis claims that no such statement can ever be justified because prices move independently of their history. The probability that they will rise next year, or next month, or today, is unaffected by whether prices rose yesterday afternoon, or last week, or in the first quarter of 2016.The weak EMH is a blow for people who rely on projections of historical trends, or identification of recurrent patterns, to make their investment decisions – most of all for chartists, whom I’ll describe in the next chapter. But the weak version does nothing to discourage people from looking at fundamental values. Rather the opposite – the weak EMH encourages you to believe that you might make money at the expense of noise traders by close attention to fundamentals.Thus there is a considerable practical difference between weak and strong EMH. Strong EMH – that everything that could be known about securities is already in their price – essentially rules out any possibility of investment skill. Legendary investors such as Buffett have simply been lucky. No research or analysis can be useful, because its results will already be reflected in the market. Put like this, the theory seems absurd.Indeed, the strong version of EMH contains an inherent contradiction. If it were the case that research and analysis could never be profitable, because the result of that research and analysis would always be ‘in the price’, why would anyone undertake such research and analysis? If markets were always efficient, what could be the process by which they become efficient?The semi-strong version of the Efficient Market Hypothesis is less extreme, claiming only that information is ‘in the price’ if publicly available. Thus the semi-strong version does not exclude the possibility that insightful new analysis, unpublished or not yet widely circulated, might be valuable to those who possess it. It certainly permits possibilities of profit from trading on private information. The investment banker who knows of a planned takeover, the corporate executive who knows that the coming results will be worse than those generally expected, can both deal advantageously on the basis of this inside information.
eBook - ePubThe Long and the Short of It (International edition)
A guide to finance and investment for normally intelligent people who aren't in the industry
- John Kay(Author)
- 2016(Publication Date)
- Profile Books(Publisher)
You regularly hear statements like these in popular discussion. The weak form of the Efficient Market Hypothesis claims that no such statement can ever be justified because prices move without knowledge of their history. The probability that they will rise next year, or next month, or today, is unaffected by whether prices rose yesterday afternoon, or last week, or in the first quarter of 2011.The weak EMH is a blow for people who rely on projections of historical trends, or identification of recurrent patterns, to make their investment decisions – most of all for chartists, whom I’ll describe in the next chapter. But the weak version does nothing to discourage people from looking at fundamental values. Rather the opposite – the weak EMH encourages you to believe that you might make money at the expense of noise traders by paying close attention to fundamentals.There is a considerable practical difference between weak and strong EMH. Strong EMH – which postulates that everything that could be known about securities is already in their price – essentially rules out any possibility of investment skill. Legendary investors such as Buffett have simply been lucky. No research or analysis can be useful, because its results will be reflected in the market. Put like this, the theory seems absurd.Indeed, the strong version of EMH contains an inherent contradiction. If it were the case that research and analysis could never be profitable, because the result of that research and analysis would always be ‘in the price’, why would anyone undertake such research and analysis? If prices were always efficient, what could be the process by which they become efficient?The semi-strong version of the Efficient Market Hypothesis is less extreme, claiming only that information is ‘in the price’ if publicly available. Thus the semi-strong version does not exclude the possibility that insightful new analysis, unpublished or not yet widely circulated, might be valuable to those who possess it. It certainly permits possibilities of profit from trading on private information. The investment banker who knows of a planned takeover and the corporate executive who knows that the coming results will be worse than is generally expected can both deal advantageously on the basis of this inside information.
eBook - PDF- Shiguang Ma(Author)
- 2017(Publication Date)
- Routledge(Publisher)
However, the original version of EMH is so engraved that it is still popular in the finance literature and textbooks. This study implements the original version of EMH in testing of China’s Stock Market. Therefore the plethora of the empirical results tested on other markets can be used as a comparative benchmark for this study. The efficient market theory and the relevant empirical studies are a popularly interesting area for research. Since the beginning of the century, a vast number of studies have been published. A complete review of the literature on efficient market is beyond the scope of this chapter. The perspectives of efficient stock market discussed in this chapter provides only a brief outline, theoretically and empirically, of the studies on market efficiency, as they relate to this study. The remainder of the chapter is arranged as follows. Section 3.2 discusses the efficient market theory and points to the relativity of market efficiency. Section 3.3 discusses the EMH and market anomalies. Section 3.4 reviews the literature on weak form efficiency. Section 3.5 reviews the literature on seasonality. Section 3.6 reviews the literature on semi-strong form efficiency. Section 3.7 reviews the literature on strong form efficiency. Section 3.8 provides a conclusion for this chapter. The Theoretical and Empirical Perspectives of Efficient Stock Market 43 3.2 Informational efficiency As stated above, internal efficiency refers to the internal mechanisms of the market. A sound mechanism is a determinant of smooth market operation. However, external efficiency relates to the outside influences on the market. Of those influences, information has the greatest effect on pricing. Usually, following the release of information, the share prices are adjusted up or down, and share returns rise and fall. The prices of shares act as signals for capital allocation into the most productive sectors.
eBook - PDF- B. Dowling(Author)
- 2005(Publication Date)
- Palgrave Macmillan(Publisher)
2 Strong EMH. It specifies that asset prices fully reflect all information from public and private sources at each and every point in time. Obviously, a Strong EMH interpretation as to the way information is imparted assumes 1 See, for example, Brunnermeier (2001) on the presence of asymmetric information and Hirshleifer and Riley (1992) for the link between information and uncertainty. 2 The term “Efficient Market Hypothesis” was coined by Harry Roberts (1967) but since Robert’s paper was never published, it was Fama’s (1970) discussion that subsequently became renown within finance circles. 10 The “Old” View of Finance 11 no “insider” information is present, that no one investor has monopolistic access to price sensitive information or no one investor has “superior” abil- ity. The obvious applied implication of such a purview is that investors cannot consistently make “above normal” profits from trading with market information – there is little point in trying to “time” the market or actively invest. Prices are assumed to adjust to new information (both private and public) instantaneously. Furthermore, many argue that the Strong EMH belief structure assumes that private information is effectively costless (e.g., Reilly and Brown (1997)) – a point we will elaborate upon in greater detail in Section 2.3. Weak EMH. It assumes that current asset prices reflect only all relevant asset market information. What precisely does this mean? Asset market inform- ation includes historical prices, market-positioning data, rates of return, volatility and so on. Basically, the Weak EMH definition implies that asset prices reflect all information that has already been generated within the mar- ketplace.
eBook - PDFAfter Enron
Improving Corporate Law and Modernising Securities Regulation in Europe and the US
- John Armour, Joseph A McCahery, John Armour, Joseph A McCahery(Authors)
- 2006(Publication Date)
- Hart Publishing(Publisher)
The Efficient Capital Market Hypothesis (ECMH) also builds on perfect market assumptions. Commenting on Fama’s 1970 seminal review article, William Sharpe stated: ‘Simply put, the thesis is this: in a well-functioning market, the prices …[of securities] will reflect predictions based on all relevant and available information. This seems almost trivially self-evident to most professional economists—so much so, that testing seems rather silly’ (Sharpe 1970: 418). William Beaver made much the same point ten years later: ‘Why would one ever expect prices not to “fully reflect” publicly available information? Won’t market efficiency hold trivially?’ (Beaver 1981: 32). In addition to its prediction of the information content of stock prices, the ECMH also played a critical integrative role, providing the necessary link between asset pricing and capital structure choice through the medium of market prices. Both CAPM and the Modigliani-Miller propositions depend on an arbitrage mechanism for their proof: mispricing will be traded away. But for arbitrage to be triggered by mispricing, market prices must be reasonably informative. Thus, along this important dimension, the positive power of the three theories rises and falls together. Despite their tautological character, all three theories generated a groundswell of angry response because, if one imagined that their predictions survived the release of their perfect market assumptions, each theory attacked the value of important participants in the capital market.
eBook - ePubUnderstanding Investments
Theories and Strategies
- Nikiforos T. Laopodis(Author)
- 2020(Publication Date)
- Routledge(Publisher)
The two capital market models we have learned, the capital asset pricing model and the arbitrage pricing theory, assumed (or were built upon) market efficiency. Their prediction is that the security’s price is fair, or in equilibrium. The paradox is, however, that both the CAPM and the APT imply market efficiency, but the reverse is not important. In other words, an efficient market can exist even when the models do not hold, suggesting that the Efficient Market Hypothesis does not imply applicability of either the CAPM or the APT. Moreover, as we noted earlier, in view of the EMH being silent on the sources of information in determining the risk-return trade-off of a security (using either the CAPM or the APT), if a shock occurs in the real economy investors would not be able to derive either model’s parameters consistent with efficient pricing. Thus asset pricing models (and modern finance theory, in general) do not help us to trace the implications of significant changes in the real sectors of the economy. Finally, in view of the existence of several anomalies (see next section), both asset pricing models need to be updated to reflect some of these anomalous situations (as we also mention in subsection 3.3).Finally, what do people say about EMH and the 2008 financial crisis? The short answer is that it is widely believed that EMH caused it. Read Box 9.3 to find out if that is true or not. The Market Flash box explains why the Nobel in economic sciences committee in 2014 decided to split the economic prize between Eugene Fama and Robert Shiller.MARKET FLASHThe 2013 Nobel Prize in Economics
The Nobel committee recognized work on the Efficient Market Hypothesis (EMH) by awarding the economics prize jointly to EMH pioneer Eugene Fama and EMH critic Robert Shiller and Lars Peter Hansen.What does it mean for markets to be efficient? According to Fama, security prices fully reflect all available information. But if the information at hand is that a company just crushed its earnings target, how is the market supposed to reflect that? Are prices supposed to double? To be able to make any statement about market efficiency, you need an equilibrium model of how security prices are set. With such a model you can make predictions that you can actually observe and test. But it’s always a joint hypothesis and this is referred to as the joint hypothesis problem. As an example, suppose your joint hypothesis is that EMH holds and the Capital Asset Pricing Model is how prices are set. The EMH says the market will get this right. So, you test CAPM and find evidence against this coupling. The problem is, you don’t know which of the two (or both) ideas you are rejecting. EMH may be true, but CAPM may be a poor model of how investors set prices because there are other risk factors besides market risk. Thus, academics have split into two groups: risk versus behavior. The risk group says the reason we are rejecting the joint hypothesis of market efficiency and CAPM is that CAPM is the wrong model of how prices are set. The behaviorists argue that the reason we’re rejecting the joint hypothesis of market efficiency and CAPM is that markets aren’t efficient because behavioral biases exist (see section 9.4 on that).
eBook - ePubDigital Signal Processing
Mathematical and Computational Methods, Software Development and Applications
- Jonathan M Blackledge(Author)
- 2006(Publication Date)
- Woodhead Publishing(Publisher)
Why should prices follow Gaussian random walks? It is often stated that asset prices should follow random walks because of the Efficient Market Hypothesis (EMH). The EMH states that the current price of an asset fully reflects all available information relevant to it and that new information is immediately incorporated into the price. Thus, in an efficient market, the modelling of asset prices is really about modelling the arrival of new information. New information must be independent and random, otherwise it would been anticipated and would not be new. The EMH implies independent price increments but why should they be Gaussian distributed? The Gaussian PDF is chosen because most price movements are presumed to be an aggregation of smaller ones, and sums of independent random contributions have a Gaussian PDF.The arrival of new information actually sends ‘shocks’ through the market as people react to it and then to each other’s reactions. The EMH assumes that there is a rational (sensible) and unique way to use the available information and that all agents possess this knowledge. Moreover, the EMH assumes that this chain reaction happens instantaneously. In an efficient market, only the revelation of some dramatic information can cause a crash, yet post-mortem analysis of crashes typically fail to (convincingly) tell us what this information must have been.In order to understand the nature of an economy, as with any other signal, one needs to be clear about what assumptions are being made in order to develop suitable models and have some way to test them. We need to consider what is happening at the microscopic level as well as the macroscopic level on which we observe financial time series, which are often averages of composites of many fundamental economic variables. It is therefore necessary to introduce some of the approaches and issues associated with financial engineering which is given in the following sections.17.13.1 Risk .v. Return: Arbitrage
For many years, investment advisers focused on returns with the occasional caveat ‘subject to risk’. Modern Portfolio Theory (MPT) teaches that there is a trade off between risk and return. Nearly all finance theory assumes the existence of risk-free investment, e.g. the return from depositing money in a sound financial institute or investing in equities. In order to gain more profit, the investor must accept greater risk. Why should this be so? Suppose the opportunity exists to make a guaranteed return greater than that from a conventional bank deposit say; then, no (rational) investor would invest any money with the bank. Furthermore, if he/she could also borrow money at less than the return on the alternative investment, then the investor would borrow as much money as possible to invest in the higher yielding opportunity. In response to the pressure of supply and demand, the banks would raise their interest rates. This would attract money for investment with the bank and reduce the profit made by investors who have money borrowed from the bank. (Of course, if such opportunities did arise, the banks would probably be the first to invest our savings in them.) There is elasticity in the argument because of various friction factors such as transaction costs, differences in borrowing and lending rates, liquidity laws etc., but on the whole, the principle is sound because the market is saturated with arbitrageurs whose purpose is to seek out and exploit irregularities or miss-pricing.
eBook - ePubMicro Markets Workbook
A Market Structure Approach to Microeconomic Analysis
- Robert A. Schwartz, Michael G. Carew, Tatiana Maksimenko(Authors)
- 2010(Publication Date)
- Wiley(Publisher)
Important formulations (such as the Capital Asset Pricing Model) are based on the assumption that expectations are homogeneous. In real-world markets, however, divergent expectations is the name of the game, and this paradigm shift has major implications (concerning, for instance, how equilibrium prices are discovered in a micro market). 5. Informational efficiency is a multidimensional concept. We consider the efficiency with which investors exploit existing information, the efficiency with which they pursue information-gathering activities, the informational accuracy of equilibrium prices, and the dynamic efficiency of information dissemination. These are not simple matters. A lot is required for a market to be informationally efficient. 6. As we turn next to a test of market efficiency, we focus on equity markets and on informational efficiency. How does one know, you might wonder, whether all existing information is fully reflected in stock prices? It turns out that there is a very clever way to infer whether prices are being efficiently set. The way involves the Efficient Market Hypothesis (EMH). The hypothesis is that information is fully reflected in stock prices, and the best-known test of the EMH is whether stock prices follow random walks. 7. Here is the logic behind the random-walk tests: If all information is reflected in a stock’s price, then there is no way to predict how the stock’s price will change in the future, because we would have no way of knowing what the new information will be. But what if future stock price changes are correlated with past stock price changes? With a correlation pattern, future price changes could be predicted from past price changes. But predictability itself is information, and acting on this information eliminates the very correlation patterns that it is based on. Once any correlation message is incorporated in price, the correlation patterns can no longer exist and price must be following a random walk. 8
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