Introduction
The Efficient Markets Hypothesis (EMH) is one of the main pillars of modern finance theory, and has had an impact on much of the literature in the subject since the 1960’s when it was first proposed and on our understanding about potential gains from active portfolio management. Markets are efficient when prices of securities assimilate and reflect information about them. While markets have been generally found to be efficient, the number of departures seen in recent years has kept this topic open to debate.
Market Efficiency
The extent to which the financial markets digest relevant information into the prices is an important issue. If the prices fully reflect all relevant information instantaneously, then market prices could be reliably used for various economic decisions. For instance, a firm can assess the potential impact of increased dividends by measuring the price impact created by the dividend increase. Similarly, a firm can assess the value of a new investment taken up by ascertaining the impact on its market price on the announcement of the investment decision. Policymakers can also judge the impact of various macroeconomic policy changes by assessing the market value impact. The need to have an understanding about the ability of the market to imbibe information into the prices has led to countless attempts to study and characterize the levels of efficiency of different segments of the financial markets. The early evidence suggests a high degree of efficiency of the market in capturing the price relevant information. Formally, the level of efficiency of a market is characterized as belonging to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strongform efficiency.
Weak-form Market Efficiency
The weak-form efficiency or random walk would be displayed by a market when the consecutive price changes (returns) are uncorrelated. This implies that any past pattern of price changes are unlikely to repeat by itself in the market. Hence, technical analysis that uses past price or volume trends do not to help achieve superior returns in the market. The weak-form efficiency of a market can be examined by studying the serial correlations in a return time series. Absence of serial correlation indicates a weak-form efficient market.
Semi-strong Market Efficiency
The semi-strong form efficiency implies that all the publicly available information gets reflected in the prices instantaneously. Hence, in such markets the impact of positive (negative) 38 information about the stock would lead to an instantaneous increase (decrease) in the prices. Semi-strong form efficiency would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. The hypothesis suggests that only information that is not publicly available can benefit investorsseeking to earn abnormal returns on investments. All other information is accounted for in the stocks price and regardless of the amount of fundamental and technical analysis one performs, above normal returns will not be had. The semi-strong form efficiency can be tested with event-studies. A typical event study would involve assessment of the abnormal returns around a significant information event such as buyback announcement, stock splits, bonus etc. Here, a time period close to the selected event including the event date would be used to examine the abnormal returns. If the market is semi-strong form efficient, the period after a favorable (unfavorable) event would not generate returns beyond (less than) what is suggested by an equilibrium pricing model (such as CAPM,which has been discussed later in the book).
The Efficient Markets Hypothesis (EMH) is one of the main pillars of modern finance theory, and has had an impact on much of the literature in the subject since the 1960’s when it was first proposed and on our understanding about potential gains from active portfolio management. Markets are efficient when prices of securities assimilate and reflect information about them. While markets have been generally found to be efficient, the number of departures seen in recent years has kept this topic open to debate.
Market Efficiency
The extent to which the financial markets digest relevant information into the prices is an important issue. If the prices fully reflect all relevant information instantaneously, then market prices could be reliably used for various economic decisions. For instance, a firm can assess the potential impact of increased dividends by measuring the price impact created by the dividend increase. Similarly, a firm can assess the value of a new investment taken up by ascertaining the impact on its market price on the announcement of the investment decision. Policymakers can also judge the impact of various macroeconomic policy changes by assessing the market value impact. The need to have an understanding about the ability of the market to imbibe information into the prices has led to countless attempts to study and characterize the levels of efficiency of different segments of the financial markets. The early evidence suggests a high degree of efficiency of the market in capturing the price relevant information. Formally, the level of efficiency of a market is characterized as belonging to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strongform efficiency.
Weak-form Market Efficiency
The weak-form efficiency or random walk would be displayed by a market when the consecutive price changes (returns) are uncorrelated. This implies that any past pattern of price changes are unlikely to repeat by itself in the market. Hence, technical analysis that uses past price or volume trends do not to help achieve superior returns in the market. The weak-form efficiency of a market can be examined by studying the serial correlations in a return time series. Absence of serial correlation indicates a weak-form efficient market.
Semi-strong Market Efficiency
The semi-strong form efficiency implies that all the publicly available information gets reflected in the prices instantaneously. Hence, in such markets the impact of positive (negative) 38 information about the stock would lead to an instantaneous increase (decrease) in the prices. Semi-strong form efficiency would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. The hypothesis suggests that only information that is not publicly available can benefit investorsseeking to earn abnormal returns on investments. All other information is accounted for in the stocks price and regardless of the amount of fundamental and technical analysis one performs, above normal returns will not be had. The semi-strong form efficiency can be tested with event-studies. A typical event study would involve assessment of the abnormal returns around a significant information event such as buyback announcement, stock splits, bonus etc. Here, a time period close to the selected event including the event date would be used to examine the abnormal returns. If the market is semi-strong form efficient, the period after a favorable (unfavorable) event would not generate returns beyond (less than) what is suggested by an equilibrium pricing model (such as CAPM,which has been discussed later in the book).
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