Page 202 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 7: Efficient Market Theory

of its importance and controversy associated with it. You should understand the analysis Notes
performed to test the EMH and the results of studies that either support or contradict the
hypothesis. Finally, you should be aware of the implications of these results when you analyze
alternative investments and work to construct a portfolio.

Did u know? Why should Capital Markets be Efficient?
As noted earlier, in an efficient capital market, security prices adjust rapidly to the infusion
of new information, and, therefore, current security prices fully reflect all available
information. To be absolutely correct, this is referred to as an informationally efficient
market. Although the idea of an efficient capital market is relatively straightforward, we
often fail to consider why capital markets should be efficient. What set of assumptions
imply an efficient capital market? An initial and important premise of an efficient market
requires that a large number of profit maximizing participants analyze and value securities,
each independently of the others. A second assumption is that new information regarding
securities comes to the market in a random fashion, and the timing of one announcement
is generally independent of others. The third assumption is especially crucial: profit-
maximizing investors adjust security prices rapidly to reflect the effect of new information.
Although the price adjustment may be imperfect, it is unbiased. This means that sometimes
the market will over-adjust and other times it will under-adjust, but you cannot predict
which will occur at any given time.

7.1 Efficient Market Hypotheses

Most of the early works related to efficient capital markets were based on the random walk
hypothesis, which contended that changes in stock prices occurred randomly. This early academic
work contained extensive empirical analysis without much theory behind it. An article by Fama
attempted to formalize the theory and organize the growing empirical evidence. Fama presented
the efficient market theory in terms of a fair game model, contending that investors can be
confident that a current market price fully reflects all available information about a security and
the expected return based upon this price is consistent with its risk. In his original article, Fama
divided the overall efficient market hypothesis (EMH) and the empirical tests of the hypothesis
into three sub-hypotheses depending on the information set involved: (1) weak-form EMH,
(2) semi-strong-form EMH, and (3) strong-form EMH. In a subsequent review article, Fama
again divided the empirical results into three groups but shifted empirical results between the
prior categories. Therefore, the following discussion uses the original categories but organizes
the presentation of results using the new categories.
The weak-form EMH assumes that current stock prices fully reflect all security market information,
including the historical sequence of prices, rates of return, trading volume data, and other
market-generated information, such as odd-lot transactions, block trades, and transactions by
exchange specialists. Because it assumes that current market prices already reflect all past returns
and any other security market information, this hypothesis implies that past rates of return and
other historical market data should have no relationship with future rates of return (that is, rates
of return should be independent). Therefore, this hypothesis contends that you should gain little
from using any trading rule that decides whether to buy or sell a security based on past rates of
return or any other past market data.

The semi strong-form EMH asserts that security prices adjust rapidly to the release of all public
information; that is, current security prices fully reflect all public information. The semi-strong
hypothesis encompasses the weak-form hypothesis, because all the market information
considered by the weak-form hypothesis, such as stock prices, rates of return, and trading

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