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Efficient Market Theories

The Theory of Efficient Market Hypothesis The Efficient Market Hypothesis (MME) was first defined by Eugene Fame in his financial literature in 1965. He defined the term “efficient market” as one in which security prices fully reflects all available information. MME is the theory describing the behavior of an assumed “perfect” market which states that: Securities are fairly priced and that their expected returns equal their required return. Security prices, at any one point, fully reflect all public information available and react swiftly to new information.

Because stocks are fully and fairly priced, investors need not waste time raying to find and capitalize on misperceived (undervalued and overvalued) securities. Therefore, the market is efficient if the reaction of market prices to new information should be instantaneous and unbiased. The efficient market hypothesis states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the MME is defined as anything that may affect prices that is unknown in the present and thus appears randomly in the future.

Evidence in favor Efficient Market Hypothesis Theory I. Stock prices are close to random walks it. Stock returns have low

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linear correlation iii. Stock returns are very hard to predict ‘v. Portfolio managers do not beat the market on average and almost no one beats the market consistently. Assumptions on the Market Efficiency I. Information is available and all investors have access to the available information about the future ‘I. All investors pay close attention to market price and adjust their portfolio appropriately iii. All of information is fully and immediately reflected in market prices ‘v.

Investors make a fair return on their investments . Investors believe that the market is not efficient, investors spend time analyzing securities searching for undervalued securities and consequently security prices react instantaneously to released information, which in turn makes the market efficient. Efficient Market Theories By bombastic There are three common forms in which the efficient market theory is commonly stated. They include:The weak form, the semi strong form and the strong form. I) Weak Form of Efficient Market The weak form MME stipulates that current asset prices already reflect past price and volume information.

The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that “everybody else knows”. This technique is so called technical analysis that is asserted by MME as useless for predicting future price changes. It asserts that it should be possible to predict future stock price movement from historical patterns e. G. A company’s Stock at NOSE has increased steadily over the past few months to the current price of SSH. 30, then this price will already fully reflect the information about the company’s growth and therefore the next change in the stock price could either be upward, downward, or constant with equal probability. It therefore follows that technical analysis or Chartist will not enable investors to make arbitrage profits. In markets that have achieved this level then security prices follow a trend less random walk Studies to test this level have been based on the principle that: The share price changes are random

That there is no connection between stock price movement and new stock price changes. It is possible to prove statistically that there is no correlation between successive changes in price of securities and therefore trend in stock price changes cannot be detected. This can be done using linear correlation (auto-correlation) test such as Durbin Watson Statistics. It) The Semi Strong Form of Efficient Market The semi strong form MME states that all publicly available information is similarly already incorporated into asset prices.

In another words, all publicly available information is fully reflected in a security’s current market price. The public information stated not only past prices but also data reported in a company’s financial statements, company’s announcement, economic factors and others. It also implies that no one should be able to outperform the market using something that “everybody else knows”. This indicates that a company’s financial statements are of no help in forecasting future price movements and securing high investment returns.

If the market has achieved this level, then fundamental analysis will not enable involves the study of company’s accounts to determine its net value and therefore find any undervalued stock. Fundamental theory states that every stock in the market has an intrinsic value, which is equal to the present value of cash flows expected from the security. Tests on Semi Strong Form of Efficient Market To test for semi-strong form efficiency, the adjustments to previously unknown information must be of a reasonable size and instantaneous.

To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner. Tests to prove semi-strong form of efficiency have concentrated on the ability of the market to anticipate stock price changes before new information is formally announced. These tests are referred to as Event studies e. G. If two companies plan to merge, stock prices of the two companies will change once the merger plans are made public.

The market would show semi-strong form of efficiency if it were able to anticipate such changes so that stock prices of the company would change in advance of the merger plans being confirmed. Other events that can affect stock prices are: Stock splits Changes in dividend policy Investment in major profitable projects Share repurchase programs Other stocks and bond sales Examples of publicly available information are Annual reports of companies Capital market reports Central Bank reports Earnings estimate disseminated by companies and security analysts. Ii) Strong Form of Efficient Market Theory The strong form MME stipulates that private information or insider information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits (past, present and future information). Thus, all information, whether public or private, is fully reflected in a security’s current market price. That means, even the company’s management (insider) are not able to make gains from inside information they hold.

For example, they are not able to take the advantages to profit from information such as take over decision which has been made ten minutes ago. The rationale behind this support is that the market anticipates in an unbiased manner, future development and therefore information has been incorporated and evaluated into market price in much more objective and informative way than insiders. If the theory is correct, then the mere publication of information that was previously confidential should not have impact on stock prices.

This implies that insider trading is impossible. Tests on the Strong Form of Efficient Market Theory To test for strong form efficiency, a market needs to exist where investors cannot are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with tens of thousands of fund managers worldwide even a normal distribution of returns (as efficiency predicts) should be expected to produce a few ozone “star” performers Tests that have been carried out on this level have concentrated on activities of fund managers and individual investors.

If the markets have reached the strong form levels, then fund managers cannot consistently perform better than individual investors in the market. Examples of strong form of efficient market information are: Imminent corporate takeover plans; Extra ordinary positive or negative future earnings announcements; Mergers and acquisitions. Implications of MME for financial decision makers I) The timing of investment policy: If the market is efficient, price follows a trend less random walk and it is impossible for managers to know whether today’s price is the highest or lowest in order to issue new stocks.

Timing other policies e. G. Release of financial statements; announcement of stock splits, e. T. C. Has no effect on Share prices. It) Project Evaluation Based upon NP When evaluating the projects, investment managers use the required rate of return particular project may be determined by observing the rate of return by shareholders of firms investing in projects of similar risk. This assumes that securities arc fairly priced for the risks that they carry (I. E. The market is efficient).

If the market is inefficient, however financial managers should be appraising projects on a wrong basis and therefore making bad investment decisions since their estimate on NP is unreliable. Iii) Creative Accounting: In an efficient market, prices are based upon expected future cash flows and therefore they reflect all current information. There is no point therefore in a firm attempting to distort current information to their advantage since investors will quickly see through such attempts.

Studies have been done for example to show hat changes from straight line depreciation to reducing balance method, although it may result to increasing profit, may have no long-term effect on share prices. ‘v) Mergers and Takeovers If shares are correctly priced then the purchase of a share is a zero NP transaction. If this is true then, the rationale behind mergers and takeovers may be questioned. If companies are acquired at their correct equity position then purchases are breaking even. If they have to make significant gains on the acquisition, then they have to rely on synergy in economics of scale to provide the saving.

If the acquirer (or the redactor) pays the current equity value plus a premium, then this may be a negative NP decision unless the market is not fully efficient and therefore prices are not fair. If markets are efficient then they reflect all known information in existing stock prices and investors therefore know that if they purchase a security at the current market price they are receiving a fair return and risk combination. This means that under or overvalued stocks do not exist. Companies should not offer substantial discounts on the security issues because investors would not need extra incentives to purchase, the securities.

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