Efficient Market Hypothesis For The Real World

Capital markets provide a function which facilitates the buying and selling of long-term financial securities to increase liquidity and their value, Watson & Head (2013). Hence, the Efficient Market Hypothesis (EMH) explains the relationship that exists with the prices of the capital market securities, where no individual can beat the market by regularly buying securities at a lower price than it should be. This means that in order to be an efficient market prices of securities will have to fairly and fully reflect all available information, Fama (1970). Consequently, Watson & Head (2013) believe that market efficiency refers to the speed and quality of how share price adjusts to new information. Nevertheless, the testing of the efficient markets has led to the recognition of three different forms of efficiency in which explains how information available is used within the market. In this essay, the EMH will be analysed; testing of EMH will show that the model does provide strong evidence to explain share behaviour but also anomalies will be discussed that refutes the EMH. Therefore, a judgment will be made to see which structure explains the efficient market and whether there are some implications with the EMH, as a whole.

It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).

Under the idea that markets are efficient, stock prices reflect new information quickly and accurately. Furthermore, Morningstar (n.d.) contributes details on the strongest supportive theory of efficient markets, EMH exists in three forms: weak, semi-strong and strong. The hypothesis calls for the existence of informationally efficient markets, were current stock prices reflect all information, and attempts to outperform the market will only come in the form of riskier investments. Also, because of a large number of independent investors actively analyzing new information simultaneously as it enters the market, investors react accordingly and is immediately reflected in the stock

Allocating the ownership of economy’s stock capital is the primary role of capital market. In an ideal market the price would provide accurate signals for allocation of resources. Ideal market is one in which firm’s production-investment decisions and investor’s decision regarding securities will depend on the assumption that the security prices fully reflect available information at any point in time. A market in which prices always “fully reflect” available information is called efficient.1

The efficient markets hypothesis (EMH) is a dominant financial markets theory developed by Michael Jensen, a graduate of the University of Chicago and one of the creators of the efficient markets hypothesis, stated that, “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis” [Jensen, 1978, 96]. This paper analyzes whether it is possible to measure if markets are efficient in the strong form of EMH. A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, Eugene Fama’s (1970) influential survey article, “Efficient Capital Markets.” It was generally believed that securities markets were

Another concern relates of insider trading of market efficiency of stock market. In his classical study Fama (1970) proposes efficient market Hypothesis, which suggests that stock price reflects all available information (historical price, public and private) in

The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to

Efficient-market hypothesis also states that it is impossible for investors to consistently out-perform the average market returns, or in other words, “beat the market”, because the market price is generally equal to or close to the fair value (Fama, 1965). It is impossible, therefore, for investors to earn higher returns through purchasing undervalued stocks. Investors can only increase their profits by trading riskier stocks (http://www.investopedia.com/). However, empirically speaking, there is a large quantity of real financial examples to support that stocks are not always traded at their fair value. On Monday October 19, 1987, the financial markets around the world fell by over 20%, shedding a huge value in a single day (Ahsan, 2012). It serves as example that market price can diverge significantly from its fair value. In addition, Warren Buffett has

When we invest money into the stock market we do it with the intention of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or ‘beat the market’. However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that security prices instantly and fully reflect all available information and that it would not be possible for an investor to make consistent excess profits. When new information

The quote shows a strong relation to the efficient market hypothesis (EMH), as it implies that the costs of capital are dependent from the amount of information given by the company.

Ever since Fama (1970) developed the Efficient Market Hypothesis (EMH) and defined the market efficiency as the strength to fully reveal all available information on the asset prices, there has been endless discussions around this hypothesis. As no arbitrage is implied, multiple theories are introduced to explore arbitrage activities and their limitations. Stephen Ross once said: “To make a parrot into a learned financial economist it needs to learn just one word – arbitrage.” Under the Efficient Market Hypothesis, there should be no trading techniques that yield positive, expected, risk-adjusted excess returns (Dothan, 2008), which in turn suggests the absence of arbitrage opportunity. Sharpe and Alexander (1990) defined arbitrage as the act to buy and sell the equivalent, or fundamentally comparable, security in two different markets at the same time to benefit from their price difference. Arbitrageurs normally look for mispriced securities and make profit through opposite positions. They long undervalued stocks and short overvalued stocks, creating upward and downward pressures on security prices towards their fundamental values.

In article of 1971, Fama categorised market efficiency into three main forms. Weak form is based on the historical data of the stock prices. The semi-strong form tests how efficiently prices adapt to the publically available information. The third form is concerned whether any given market participants having monopolistic access to the creation of the stock prices.

The efficient markets hypothesis posits that “security prices fully reflect all available information (Fama, 1991).” In an efficient market, a stock’s price accurately depicts its fundamental value. However, researchers have shown that real markets are actually inefficient, and are hindered by risky arbitrage and irrational investors. Because of market frictions, incomplete information, and systematic biases, stock prices react to changes in uninformed demand in addition to actual fundamental shifts, resulting in sustained and pervasive mispricing. This essay aims to challenge the theory of market efficiency, and in so doing, support the position that stock prices do not always reflect stocks’ fundamental values.

“In an efficient market, security (example shares) prices rationally reflect available information” (Arnold 2005, p.684). The efficient market hypothesis

If a capital market fully and accurately reflects all relevant information when determining the price of the securities, the market is effective and the three characteristics of the effective capital market are efficient operation, efficient price, and efficient distribution(Sascha Kurth,2013). There are three forms of efficiency market, this article will analyze the characteristics of semi-strong effective market and the impact of the abnormal Book-Market-value effect on the effective market hypothesis so that investors should be dialectical view of the market hypothesis and the emergence of abnormal to make the stable investment activities.