Efficient Market Theory and Hypothesis

Pages: 5 (1782 words) Published: January 3, 2013
Part 1
According to the model of efficient market, the stock prices should be taken as the best forecast to calculate the discounted future dividend provided with an available information set. The efficient markets theory (EMT) explains that all relevant information about the intrinsic value of an asset is reflected in the price of that asset (Dimson and Mussavian 2000). Hence, this theory assumes that the financial markets tend to be efficient in information. Market efficiency is further classified into three forms by Fama (1970) namely; weak form market efficiency, semi-strong form and strong form market efficiency. A market is efficient in weak form if the predictions regarding stock price changes could not be made based on information about past returns or any other market based indictor e.g. ratio of puts to calls and the trading volume. A market will be considered weak form efficient when the information about historical prices is reflected in the current prices. This implies that the stock prices will be serially correlated and thus the investors cannot develop a trading rule which is based on past price patterns in the hope of earning an abnormal return. The semi strong form of market efficiency is based on the notion that the stock prices will immediately reflect any recent publicly available information(Dimson and Mussavian 2000). Here it is assumed that security prices will instantaneously respond to any new information which means that for it is difficult for the investors to make excessive returns by basing their trading rules on the publicly available information. In this case the market will not delay or over act in response to new information set. The third form of market efficiency is the strong form which states that whether the information is available publicly or privately, the prices will reflect all types of information. What this means is that even if the information which is held privately or received from hidden sources, it will be reflected in the stock prices(Fox 2009). This is rather an extreme case of market efficient behaviour and serves as a limiting case as it assumes that the stock prices will reflect even the information from personal sources however, it is conditional on whether such information will be reported by the corporate officers about their own firm.

Part 2
The central idea of the efficient market theory is that as the stock prices reflect all the available information hence, there is no possibility for any investor to earn excess profits by any means. According to this hypothesis it is unlikely and very difficult for an investor to make profit by predicting the price movements. The main driver behind this is the arrival of new information. The theory that stock market share prices fully and fairly reflect all known information is a much debated and critiqued topic as there are many academics who doubt this. For this it becomes necessary to discuss the evidence for and against the theory. There is much realistic evidence when one analyses the three forms of market efficiencies. The weak form simply puts that it is impossible to make a profit by using the past information about stock prices. This is very true as there is a transaction cost involved in analysing as well as trading securities which automatically eliminates any profit. The second form of market efficiency is basis its argument on the assumption that an individual cannot make profit from the publicly available information. This is also realistically true as obtaining and analysing the large sets of public information is not possible and the skills required to analyse such information take a huge amount of time to develop. Hence, it seems unrealistic that investors will profit from something like this. Other than these evidences, there are some tested and proven evidence which supports the efficient market hypothesis. In the weak form of efficiency many studies have been formulated to test the hypothesis that...

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DeBondt, W., and Thaler, R., 1985. “Does the Stock Market Overreact,” Journal of Finance. 40(3), pp. 793-805.
Dimson, E., And Mussavian, M., 2000. Market Efficiency. The Current State Of Business Disciplines, 3, 959-970.
Fama, E. F., 1965. The Behavior of Stock-Market Prices, Journal of Business, 38, (1), 34-105.
Fama. E. F., 1970. Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, 25(2), 383-417.
Fox, J., 2009. The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. Harper Business.
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Jensen, M., 1969. Risks, the Pricing of Capital Assets and the Evaluation of Investment Portfolios, Journal of Business, 42(2), 167-247.
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