Empirical Evidence for the Efficient Market Hypothesis
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Outline various versions of Efficient Market Hypotheses. Discuss whether there is sufficient empirical support for each of these hypotheses.
The efficiency of financial markets has long been a contentious issue, and as financial markets have evolved both in their breadth and complexity the question whether financial markets can effectively and efficiency allocate resources has never been more relevant. In this essay I intend to investigate the validity of the various forms of the Efficient Market Hypothesis (EMH) using empirical evidence from various studies; and attempt to determine whether any of these forms of the EMH are accurate in describing the workings of international financial markets. Traditional finance textbooks have long offered three ‘versions’ of informational efficiency of financial markets: Weak, Semi-Strong and Strong, with the definitions of these ‘versions’ relatively settled. I will firstly outline these versions and then evaluate the evidence to determine their validity. The Weak form of the EMH asserts that financial markets efficiently process all past prices of a financial asset which are reflected in its current price. Furthermore, it implies that asset prices follow a random walk process. This renders technical analysis futile as all information contained in previous prices has been efficiently priced in. Formally: ( ) ( )
The weak form of the EMH has had a substantial amount of research into testing its validity, in particular using econometric analysis. In addition, several observable phenomena have been presented as evidence against the weak form of the EMH. The ‘December Effect’ is an empirical observation that during the month of December stocks generally outperform when compared to the rest of the year, this effect has been long observed and appears to have continued to persist (Since 1950 December has been the best performing month for the S&P 500 with an average return of 1.62%). This poses a contradiction to the
Outline various versions of Efficient Market Hypotheses. Discuss whether there is sufficient empirical support for each of these hypotheses.
The efficiency of financial markets has long been a contentious issue, and as financial markets have evolved both in their breadth and complexity the question whether financial markets can effectively and efficiency allocate resources has never been more relevant. In this essay I intend to investigate the validity of the various forms of the Efficient Market Hypothesis (EMH) using empirical evidence from various studies; and attempt to determine whether any of these forms of the EMH are accurate in describing the workings of international financial markets. Traditional finance textbooks have long offered three ‘versions’ of informational efficiency of financial markets: Weak, Semi-Strong and Strong, with the definitions of these ‘versions’ relatively settled. I will firstly outline these versions and then evaluate the evidence to determine their validity. The Weak form of the EMH asserts that financial markets efficiently process all past prices of a financial asset which are reflected in its current price. Furthermore, it implies that asset prices follow a random walk process. This renders technical analysis futile as all information contained in previous prices has been efficiently priced in. Formally: ( ) ( )
The weak form of the EMH has had a substantial amount of research into testing its validity, in particular using econometric analysis. In addition, several observable phenomena have been presented as evidence against the weak form of the EMH. The ‘December Effect’ is an empirical observation that during the month of December stocks generally outperform when compared to the rest of the year, this effect has been long observed and appears to have continued to persist (Since 1950 December has been the best performing month for the S&P 500 with an average return of 1.62%). This poses a contradiction to the
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