The Development of Efficient Market Hypothesis

Topics: Efficient-market hypothesis, Random walk hypothesis, Financial markets Pages: 8 (2951 words) Published: February 21, 2013
The Development Of Efficient Market Hypothesis

Xiao Yang

FIN 790 Spring 2013
January 30, 2013

For many years, many economics have been interested in developing and testing models of stock price behaviour. Market Efficiency is one of the important financial theories on stock price behavior. Many basic financial theories, such as Capital Asset Pricing Model (CAPM), Portfolio Theory, and Option Pricing Model are based on Market Efficiency. The Efficient Market Hypothesis( EMH ) is an economic theory on the efficiency of capital markets. In the year of 1970, the EMH was first officially formed by Fama in the article of "Efficient Capital Markets: Theory and experience Research", which expounded Fama's EMH. And this article is generally believed to be the milestone on the study of how stock market price performs or reflects all kinds of available information and how stock markets prices rapidly adjust to any new information efficiently. EMH states that in an open and efficient market, security prices should fully reflect all available information and prices rapidly according to any new information. As a result of efficient market, market prices are always ‘correct’ for securities and reflect the best available estimate of their true intrinsic worth. Investors who agree with this statement tend to buy index funds that track overall market performance. In his point, Fama believes that there are three different efficiency market patterns according to the degree on how security prices reflects the information. The three different efficiency market patterns are: 1) weak form of efficiency market (price fully reflects the historical information); 2) semi-strong form of efficiency market (prices fully reflect all publicly available information); 3) strong form of efficiency market(prices fully reflect public information and non-public information). In short, the theory of the EMH is developed from the theory of random walks. Since the EMH was proposed by Fama, it had been applied to many financial practices especially in the research of information disclosure of stock markets.

Literature Review
1.The Theory of Random Walks in Stock Prices
The theory of random walks is a financial theory which states that stock market prices change like a geometric random walk. This concept of random walks can be traced to Eugene F .Fama's "The Behavior of Stock-Market Prices" published in the Journal of Business in 1965 before EMH was initially presented in 1970, As Fama claimed in his article, "The purpose of this paper has been to test empirically the random-walk model of stock price behaviour. The theory of random walks in stock prices actually involves two separate hypotheses: (1) successive price changes are independent, and (2) the price changes conform to some probability distribution." (FAMA 35) Fama believes that, successive price changes are independent and are consistent with the existence of an "efficient" market for securities. That is, if given the available information, a market where actual prices at every point in time represents very good estimates of intrinsic values. If the stock price does not follow a random walks model, then the investors can take advantage of the price difference on the market to earn excess profits. Also stock price regression can also encourage investors to earn the difference. Fama presented strong and voluminous evidence in favor of the random walks model. After some tests in empirical research, he confirmed that stock prices follow a random walk hypothesis of this feature in the empirical analysis. In his tests of empirical research, Fama used Gaussian hypothesis and the Mandelbrot hypothesis. Although the Gaussian or normal distribution does not seem to be an adequate representation of distributions of stock price changes. the conclusion is that a stable Paretian distribution...
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