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Efficient market hypothesis also known as “Random walk theory” (Kendall 1953). Efficient market hypothesis is thought of “random walk” which used in finance to demonstrate the price chain where all the ensuing prices changed randomly from earlier prices. The random walk idea is the flow of unrestricted information that reflected in stock prices. So, tomorrow’s prices change will effect only on tomorrow news and the independent price changes today. Thus efficient market hypothesis define as
Most of research shows how capital market is to be efficient. Empirical studies continues to know about is capital market are or not informational efficient. An efficient market also observes the performance of investment and mutual funds (an investment consists of portfolio of stocks, bonds or other securities). Many researchers study has been taken on this field at first start the hypothesis take its roots in 1960s that how market is capable, starting with some researches
Eugene Fama 1965 Introduce the term “efficient market” also differentiate between forms of efficiency weak, semi-strong and strong
Samuelson 1965 Primary development in EMH and conditions of modern financial economics as options of pricing
Harry Roberts 1967 Study on EMH and difference between weak and strong form test
Peng et al 1994 Work on dependences of financial assets prices on the market
Lo & Mackinely 1999 Study on behavioral finance (psychology on behavior of investor)
Mamaynski & Wang 2000 Tested on random walk using difference ratio test
Blumne, Durlauf 2008
Presentation efficient capital market is correlate with cost efficiency
Jhon L.Teall 2013 & 2018 Work on financial trading and investing( part 1 in 2013 and
Part 2 in 2018)
Public or confidential information how generate the abnormal profit.
Dr.Thorsten Hens 2015 Work on behavioral finance and investor psychology
Efficient market hypothesis and its critics
Grossman 1976 Disagree with fama’s definition of EMH “fully reflect”
Grossman & Stiglitz 1980 He said definition of “efficient market”
is unclear if investors have various information then how market has used efficiently all on hand information to find out price of stock.
Warren buffet 1984 Criticized on fama’s study
He said if stocks prices are reflect ground rules, then why they are so unpredictable.
Leory 1989 Condemn fama’s definition of “efficient market”
He said definition is unclear if investors’ having various information then how market has used efficiently all on hand information to find out price of stock.
Jegadeesh & Titman 1993
Cancelled EMH by finding that stocks have abnormal negative in12 month after conception of portfolio
Malkiel 2003 Disagree that market can be efficient if investors were irrational and stock prices are unstable
Goedhart, Koller ,Wessel 2010 Research that uneven transaction cost and difference in investor awareness avoid change in value that later reflected in market price.
Horvatic et al 2011 Study fluctuation analysis to challenged “random walk”
In financial economics, efficient market also states “beat the market” as efficient stock market sources the share price to fit in and reflect all the related information. According to the EMH in stock exchange stocks always trade at their fair value and it is impossible for investors to purchase the undervalue stocks or sell the inflated prices of stocks. Some assumptions are made that how market is to be efficient
There are three major version of hypothesis;
Because of finding on short term and long term reaction on stock prices, first what is a weak form of EMH?
Weak form of EMH state that stock price combines only information those were only in past history of prices. In this condition one cannot get the profit from the information that is common to everyone. Most of the financials study show that how the hypothesis claims how to create profits without value, the past chain of stock prices and dealing volume data this technique called methodological study.
This technical analysis is reasonably strong and reliable. In weak form of EMH information is both publically and private information is accessible for everyone. Weak form of EMH it is impossible to know the historical market information and movement of past stock prices to forecast future price movement. In weak form of EMH there is large chance of fluctuation.
The semi-strong form of EMH state that currently stock price have publically information, including expecting micro-economic factor, data that were reported in company financial statement, declare merger plan, earning and historical prices. Prices will respond instantly to publically on hand information in semi-strong efficient market. Just like the weak form of hypothesis in semi-strong, information is publically available so one not be able to get the profit by using the resources that also available for every person. It is complicated to collect and expensive procedure on the basis of public information.
For example in semi-strong efficient market stock prices replicate according to the new information of a company. In semi-strong, other public information builds in proportion such as price to book value, P/E ratio. Through researches scholars initiate that empirical data mostly consistent with semi-strong form of efficient market hypothesis. In semi-strong EMH only public information is available and in impartial manner, private information is not available. Some chance to forecast the future price movement.
In strong form of efficient market hypothesis, share prices are both public and private information is available excess return cannot be earned by anyone. Strong form of EMH become impossible if legal obstacles of private information becomes public, according to insider trading law. If testing the strong form of hypothesis, market should survive someplace where investor does not earn excess return for long period of time.
Even if some financial managers constantly observe to beat the market, it should not be followed even a normal distribution. As a result, stock prices are slot in both public and private information. Thus, the empirical evidence not dependable on strong form of hypothesis. The strong form widens the market to make the perfect market where all information is available to the investors and at a same time no cost.
Efficient market hypothesis define as that financial markets are“ informational efficient” thus the result is one cannot earn excess return on risk- adjust base in average market as information is available at investment time. If we see in past there is bond between random walk model and Martingale model. In 1863 Jules Regnault made first model of random character of market stock prices. Some model and behavior of EMH are
Through analyzing it suggest that random walk is a character stock price. Theory random walk state that evolution of future prices cannot be predicted. The increase of specific day does not affect automatically increase or decrease of following days. So, as a result it state that prices does not have memory. During 1930-1940 researchers and scientists ignore the random walk theory. Many authors accomplished that investors does not manage or average the abnormal return as compared to various markets. After completing PhD paper, in late 1960s-and early 1970s Eugene Fama bring out random walk theory his theory were based on empirical study.
During 1990s new idea took place of behavioral finance. This study tells about the influence of investor behavior and opposes the random walk theory hypothesis by Lo and Mackinely (1999) and Mamaynski and Wang (2000). By using the different ratio test they tested the random walk theory the idea is that holding period and variance should be linked, with a linear relationship.
This model defines as level of any variable is equal to the price of that variable “t” that is used in past information. This model is normally linked with efficient market hypothesis. This model is used to define weak form of efficient market
This model is model of fair game in which past information is not useful to forecast the future gain. This model is not related in a way of risk hypothesis Tradeoff among risk and predictable return these were pillar of modern finance theory. Still by this limit, martingale model is used for pricing theory after ensuring the risk adjustment model.
The study state that short term effect on financial asset that prices were clashing the market. The study based on how prices quickly react to new information that released in the market .many researcher included Fama, Fisher accomplished that positive largest abnormal return are trace in 3-4 months after publication of prices that are gradually adjusted in capital market. In market stocks prices react slowly to new information after the announcement during first 12 and EMH invalidate. After many researches it concluded that none of countries have efficient capital market in weak form and have different maturity level of each market. Some articles also suggest that insiders have stable and major abnormal returns; So EMH is not constant at this state.
Not all paper conclude that all markets are inefficient, According to Malkiel (2003) his research state that capital markets are efficient and less expected than other author shows in their work. Many other suggest that anomalous behavior also effect on stock prices and it generate portfolio dealing opportunity that facilitate investor earn abnormal risk common return. Malkiel also suggested that anomalies not largely cover transaction cost which incurred by investor and obtain major positive abnormal return above market. Some possible explanation is being considered difference in maturity level of all market.
In long term how author examine how stock prices react in a split of events. This results in that the split event has larger level of distribution profits as dividends. That determines how at the end of month or directly investor reflect on larger future income, means how stock prices increases after declaration. Debondt and Thaler (1985) issued investigate long term stock return. This study is based on how investor invests in increase in return on stocks during definite period of time, so EMH is infirm. In 1994, Lakonishok concluded that the companies having high values of E/P (earning/price), CF/P (cash flow/price), BE/ME (book-to-equity) have poor historical development of stock prices. On other hand, companies with these indicator having small values emerge as historical increasing average return. This shows the future performance of companies those hold first groups were expected as better than second category of companies, so semi-strong form of EMH does not hold in this.
Some researchers were conducted before the improvement in theory that states the companies keeps shares as an alternative of paying dividends in case if they are not sure that their dividends policy were stable over long term run. About the finalization of IPO (initial public offer) the reduction of stock prices on long run is caused by investors over reaction at the moment of the events publication (Dharan &Ikenberry 1995). Not all researchers prove that investors reaction after the release of an event moving in a single direction in that case investor choose invest in a single way, which is not possible. In that case prices take large period of time adjusted to their normal value. As a result these researches continuous for more empirical researches and more focused on reality of the models.
Insider trading is known as buying and selling of securities prices held by publicly company through a person who has private information about plan and financial state of a company. In today’s surroundings, both legal and illegal insider trading is available. There is method of insider trading whenever company trade they must inform their trade to SEC. It a signal for investor that were outside, these outsider investor are opposite of insider investor, not able to private information of a company. Those who buys the shares have information and they assume that share prices will goes up and those who sells the share will also have inside information that share price will reduce.
The policies and law for insider trading is different in every country. Insider trading is both legal and illegal but many researchers have study and find out is link between efficient market hypothesis and insider trading also examines that there is higher abnormal return due to insider trading.
Efficient Markets Hypothesis - Understanding. (2020, Nov 28). Retrieved from https://studymoose.com/efficient-markets-hypothesis-understanding-essay
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