The Efficient Market Hypothesis

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The efficient market hypothesis (EMH) is an important assumption in finance. What are the various forms of the EMH? Does the EMH in any of its forms make sense given the current economic circumstances? The efficient market hypothesis (EMH) is an important assumption in finance. What are the various forms of the EMH? Does the EMH in any of its forms make sense given the current economic circumstances?

Hariem Haladni
Hariem Haladni

September 2012

September 2012

In modern financial economics, one of the most essential constructions , which plays a significant role in financing strategy, is efficient market hypothesis (henceforth EMH). Despite the fact that its first theoretical formulation, which was founded by Paul Samuelson in 1960s, is almost five decades old, numerous academic studies have been conducted about it (Alajbeg, Bubas & Sonje, 2012). According to Alajbeg et al. (2012), in the middle of 1960s market efficiency was defined by Samuelson as the existence of a complete competition in a market, albeit under an assumption that all participants have equally the same opportunity to access the available information. Furthermore, Fama (1965) cited in Alajbeg et al. (2012) attempts to show the EMH empirically. This essay will try to critically debate all the forms of efficiency and give sensible evidence why most of the forms seem to be illogical in the current economic situations. It will start by introducing how to recognise efficiency and what are the forms of the EMH, following by testing each form in today’s economic circumstances with presenting coherent arguments. Damodaran (2001) points out that market efficiency is distinguished by three different measurements. First is considering the amount and the distance of diverting price from real value in the market. The second measure is by looking at the pace and the quantity of adapting prices to new information which come to the market. Finally, it is measured by determining the possibility of usual gaining higher profits by some investors in the market while they may expose the same rate of risk that other investors reveal. Generally, economists have divided the EMH into three main forms based on the type of the information reflected in security prices. The first type of the EMH is weak form. In this form of efficiency, the only information depending on is the past prices information. However, any other available stock information seems to be invaluable in these markets. As Hillier, Ross, Westerfield, Jaffe & Jordan (2010) state no information, apart from the historical prices, is relied on by the investors in the weak form efficiency. In the light of this, a capital market is considered to be weakly efficient when it contains price information about the past share prices. Hillier et al. (2010) also confirm that predating strategy is unlikely to be able to produce returns in the market operations. Put another way, information for future is not predicted in this form of efficiency. This seems to be a possible reason why these markets are called weak efficiency. The second type of the market efficiency is semi-strong form. According to Ross, Westerfield & Jordan (1993), the semi-strong efficiency is the most controversial form among all the three forms. From this perspective, Ross et al. (1993) mention the reason why this form in the markets is more controversial than the other forms is that it warns an expert, who analysis financial information in order to find mis-priced stock, to not waste time in analysing some possibly useless information, for instance, financial statement information because this information is already included in the current stock prices. Brealey, Myers & Allen (2011) maintain that in these markets, prices rapidly incorporate whole publicly available information, such as last quarters earning declaration, a proposal of unifying other companies and an unfamiliar matter of stock. In the light of this finding, it...
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