DFA1035 Y Fundamentals of Finance and Practice

UNIT 14 THE EFFICIENT MARKET HYPOTHESIS

Unit Structure

14.0 Overview
14.1 Learning Outcomes
14.2 Origins of the Efficient Market Hypothesis & the Efficient Market
14.3 Understanding the Efficient Market Hypothesis
14.4 Testing for Market Efficiency
14.5 Forms of Efficiency
14.5.1 Weak Form of Efficiency
14.5.2 Semi-Strong Form of Efficiency
14.5.3 Strong Form of Efficiency
14.6 Testing the three forms of Market Efficiency
14.6.1 Weak Form Efficiency
14.6.2 Semi Strong Form Efficiency
14.6.3 Strong Form Efficiency
14.7 Implications of Market Efficiency for Corporate Managers
14.8 Stock market Anomalies
14.8.1 Size effect
14.8.2 Day of the Week effect
14.8.3 January effect
14.9 Activities
14.10 Summary
14.11 Suggested Reading
14.12 Useful Links

1
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

14.0 OVERVIEW

The Efficient Market Hypothesis (EMH), developed independently by Paul A Samuelson

(1960) and by Eugene Fama in the late 1960s and early 1970s, asserts that financial markets are
"efficient” or that the price of a traded asset such as a stock, bond or property already reflects all
known information and therefore is unbiased in the sense that they reflect the collective beliefs
of all investors about future prospects. According to EMH, it is not possible to consistently beat
the market (appropriately adjusted for risk) by using any information that the market already
knows, except through luck or obtaining and trading on inside information. In the EMH context,
information or news is defined as anything not known in the present but which appears randomly
in the future and as a result, may affect stock prices. Thus, this random information will be the
cause of future stock price changes.

14.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following:

1. Define an efficient market.
2. Explain the Efficient Market Hypothesis
3. Describe the various forms of Market Efficiency.
3. Describe how can the validity of the different forms of market efficiency be tested.
5. Analyse the implication of EMH in modern finance.
6. Explain what are stock market anomalies.

14.2 ORIGINS OF THE EFFICIENT MARKET HYPOTHESIS & THE

EFFICIENT MARKET

Read: Chapter Eleven, Page 315, Capital Market Efficiency - Book FCF, 2nd European Ed.

One can trace back the origins of the Efficient Market Hypothesis in Eugene’s Fama college
work on the random walk hypothesis. The job assigned to Fama by Professor Harry Ernst was

2
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

about studying past prices with a view to identifying profitable trading systems for stock price
prediction (called technical analysis). However, it was found that although trading systems
could be applied to historical data, they could hardly be used for actually predicting movement of
stock prices in a real investing situation.

During his work, Fama also introduced the “efficient market” term which was described as “a
situation where successive price changes are independent or a market where, given a set of
available information, actual prices at any time, t, represent very good estimates of intrinsic
values”.

14.3 UNDERSTANDING THE EFFICIENT MARKET HYPOTHESIS

Read: Chapter Eleven, Page 317, The Efficient Market Hypothesis - Book FCF, 2nd European Ed.

Why is there a need to determine the true value of a stock? Well, simply to be able to identify
undervalued and overvalued stocks and accordingly take the appropriate investment or sale
decision. Many investors tend to use different stock picking and market timing techniques to
choose shares that can yield a return better than the market return. However, the EMH asserts
that no technique is effective, in the sense that the gain does not exceed the research and
transaction costs, and thus no investor can forecast to beat the market.

The EMH’s concept of informational efficiency is such that the more efficient the market is, the
more unpredictable the prices changes are by such a market, and the most efficient market of all
is one in which price changes cannot be forecasted at all.

This state of the market can be explained by the actions of most active traders on the market. In
their quest for more profit, they tend to capitalise on the smallest information that they possess.
This information then gets reflected in the price of the share and as a result the profit motive
wanes and gradually disappears. In case the market reacts immediately, then all available
information is fully reflected in share prices at any point in time and thus no profit can be earned.
3
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

Now, if the share price contains all information, then the share price should reflect the
true/intrinsic value of the share. Thus an efficient market is one where the market price is an
unbiased estimate of the true value of the security.

It should be noted that at times in an efficient market, the share price can temporarily differ
from the share value. The chance that share price is superior to share value is equal to the chance
that share price is inferior to share value. The difference between the two values is mainly due to
unanticipated information. There are analysts/professionals who study the price and value of
shares and when they observe differences between the two values, they either buy or sell the
shares (i.e. undervalued shares are bought and overvalued shares are sold). As there is a large
demand (undervalued shares) or large supply (overvalued shares) for the shares, their prices will
decrease or increase and their prices will tend towards the true value of the shares.

The following assumptions are made on an efficient market:

(i) It is assumed that all investors are rational.

(ii) It is not possible to consistently make abnormal return on an efficient market.
(iii) All investors have free access to all information that is integrated in the prices of
securities.
(iv) There are no transaction costs (e.g. costs incurred for searching new information on
stock market).

4
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

14.4 TESTING FOR MARKET EFFICIENCY

Until now, we have seen that if a market is efficient, then:

(i) At all moments, all information is incorporated in share price.

(ii) Due to the occurrence of unanticipated events (information), future share prices cannot be
predicted.
(iii) Market efficiency also implies that share price must be equal to share value. (Thus
investors/professionals cannot consistently generate gains on the stock market if the
market is efficient)

In an efficient market, at all times all information (anticipated past and future information +
unanticipated information) is integrated in share price and an investor/professional cannot predict
future share prices.

There has been much debate about whether the market is really efficient. Many researches have
worked on this topic and through experiments have tried to conclude if markets are efficient or
inefficient. Some research works have been geared towards trying to predict future share prices,
by taking into consideration different levels of information. If it is concluded that future share
prices can be predicted, by using a certain level of information, this means that the market
is not totally efficient. Or if investors can consistently make gains on the market, then the
stock market is not really efficient.

14.5 FORMS OF EFFICIENCY

Read: Chapter Eleven, Page 318, The Forms of Market Efficiency - Book FCF, 2nd European Ed.

There are 3 forms of market efficiency and it is observed that the amount of information
available increases as we move along the different categories of market efficiency.

5
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

(i) Weak form efficiency: information on past share prices available

(ii) Semi-strong form efficiency: information on past share prices + public information
available
(iii) Strong form efficiency: information on past share prices + public information +
private information available

Each has different implications for how markets work.

14.5.1 Weak Form Efficiency

In the first case, it is assumed that information on past prices of shares is available to
investors/professionals; this means that the current share price reflects information contained in all past
prices. In this case, it is said that the market is weak form efficient.

If investors could have predicted future share prices by studying past share prices, there should have been
a certain pattern in the evolution of share prices (e.g. share prices move in cycles). By studying any stock
market, it is seen that past share prices do not follow any regular pattern. This means that past prices
cannot be used to predict future share prices. This suggests that charts and technical analyses that use
past prices alone would not be useful in finding undervalued stocks.

14.5.2 Semi-Strong Form Efficiency

In a semi-strong form efficient market, the current share price incorporates information contained in past
prices and also takes account of all public information. All investors/professionals can have access to
public information (examples of public information include financial statements and news reports). New
public information is almost instantaneously integrated in the share price and the share price is adjusted so
as to reflect the true value of the share. So the investor who possesses public information cannot use the
information to generate gains on the stock market.

14.5.2 Strong Form Efficiency

Under strong form efficiency, the current price reflects all information, public as well as
private. On the stock market, there are professionals (e.g. security analysts), who obtain private
6
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

as well as public information. As new public and private information is released, it is

incorporated in share price to reflect its true value. The investor will not be able to consistently
find undervalued shares (for buying) or overvalued shares (for selling) and make gains on
the stock market, which is strong form efficient.

Even the “insiders” of a particular company’s management cannot profit consistently from inside
information by buying the company’s shares immediately after they decided (without making a
public announcement) to go for a profitable venture. The rationale for strong-form market
efficiency is that the market anticipates, in an unbiased manner, future developments and
therefore the stock price may have incorporated the information and may have been evaluated in
a much more objective and informative way than the insiders.

14.6 TESTING THE THREE FORMS OF MARKET EFFICIENCY

Some observers dispute the notion that markets behave consistently with the EMH, especially in
its stronger forms. Some economists, mathematicians and market practitioners cannot believe
that man-made markets are strong-form efficient when there are prima facie reasons for
inefficiency, including the slow diffusion of information, the relatively great power of some
market participants (e.g. financial institutions), and the existence of apparently sophisticated
professional investors. The way that markets react to news surprises is perhaps the most visible
flaw in the efficient market hypothesis. For example, news events such as surprise interest rate
changes from central banks, are not instantaneously taken account of in stock prices, but rather
cause sustained movement of prices over periods from hours to months.

14.6.1 Weak Form Efficiency

In order to test whether past share prices can be used to predict future share prices (i.e. test if the
stock market is weak-form efficient), statistical or econometric tests can be used. In most
cases, these tests have shown that the evolution of share price from one period to the next period

7
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

is independent (i.e. that is the share price at period two does not depend on the share price at
period one).
Technical analysts study the evolution of past share prices, so as to predict future share prices.
The predictions made in the past by technical analysts can be studied in order to test weak-form
efficiency.

Inefficiency was commonly believed to exist in the United States and United Kingdom stock
markets. However, earlier work by Kendall (1953) suggested that changes in UK stock market
prices were random. Later work by Brealey and Dryden, and also by Cunningham found that
there were no significant dependences in price changes, suggesting that the UK stock market was
weak-form efficient

14.6.2 Strong Form Efficiency

Testing whether past share prices and public information can be used to predict future share
prices (i.e. test if the stock market is semi-strong form efficient) requires a researcher to perform
event studies. Event Studies enable the effect of the release of new public information on the
share price to be determined. In a semi-form efficient market when new public information (e.g.
the company announces a merger or an acquisition) is released, it is instantaneously impounded
in the share price, so as to reflect the true value of the share. Following the release of the new
information, the share prices will instantly increase or decrease depending upon whether it is a
good news or bad news.

In the majority of cases, on a stock market, new public information is almost immediately
integrated in share prices to reflect its true value. If this were not the case (i.e. share price inferior
to share value or share price superior to share value), then investors/professionals who are aware
of the new public information would exploit the situation (undervaluation or overvaluation of
shares) in order to make gains. It is known that investors/professionals can temporarily make
gains by exploiting the situations where share value is different from share price. The demand of
undervalued shares and offer of overvalued shares will respectively cause a price increase and a
price decrease; thus share prices move towards their share value.
8
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

Empirical studies undertaken by different researchers, at different points in time, on the forms of
market efficiency have had different results. For example, on one hand, some found that the UK
stock market is weak form efficient while others identified it as being semi-strong form. One
particular study by Firth in the late seventies in the United Kingdom had compared the share
prices existing after a takeover announcement with the bid offer. It was found that the share price
had correctly and fully reacted to the information confirming the existence of a semi-strong
efficient market in UK.

14.6.3 Strong Form Efficiency

In order to test whether past share prices, public and private information can be used to predict
future share prices (i.e. test if the stock market is strong form efficient), the investment records
and gains generated by professional investors (e.g., mutual fund managers) can be studied.
If it is found that by using public and private information these professionals cannot consistently
make gains, then it can be concluded that the market is strong form efficient. This means that at
all moments the share prices incorporate all public and private information to reflect the true
value of the shares (i.e., share price = share value), then professionals cannot obtain gains from
these shares.

14.7 IMPLICATIONS OF MARKET EFFICIENCY FOR CORPORATE

MANAGERS

If markets are efficient, then corporate actions are rapidly being reflected on the share prices.
Essentially, this will mean that managers make decisions on the firm and investors respond to
those decisions on the firm and investors respond to those decisions through the market prices.
As such, management should attempt to maximize shareholder wealth. On the other hand, when
markets are efficient, investors have access to more information and they react rapidly to any bad
news. Thus, managers must be careful in using creative accounting techniques to boost corporate
reported earnings but not cash flows as investors are not easily fooled. Moreover, when

9
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

managers have information not yet released to the market, they may have some opportunities for
influencing prices. Finally the timing of new issues will matter little as market prices will be a
fair reflection of the information available.

14.8 STOCK MARKET ANOMALIES

There are some observed phenomena on stock markets that are against Efficient Market
Hypothesis.

14.8.1 Size Effects

Studies have found that small companies seem to earn higher average return than larger
companies (Dimson & March, 1986). Differences in performance may be related to higher risks,
trading costs and institutional neglect. Financial institutions tend to ignore smaller companies as
their maximum investment is relatively small.

14.8.2 Day of the Week Effects

Fran Cross (1973) and Gibbon & Hess (1981) found in their research that share performance is
related to the day of the week. Essentially, prices tend to fall on Mondays and rise on Fridays –
the Monday Effect. This behavior is supposed to be associated with the fact that investors treat
buying and selling decisions differently, in particular, they are more cautious in their buying
decisions, seeking broker’s advice. Essentially, the investors will evaluate their portfolios over
the weekend and then decide what to sell on Monday.

14.8.3 The January Effect

According to Hangen (1997) and Weim (1983) , returns in January tend to be relatively higher
compared to other months and it is more pronounced for small firms. The reason behind this
anomaly seems to be the existence of “window-dressing”. Fund managers sell smaller stocks in
December and buy those smaller stocks in January so as to leave a better impression on their
clients at the end of year.

10
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

14.9 ACTIVITIES
Activity 1

What are the implications of the efficient markets hypothesis for investors who buy and sell
equities in an attempt to “beat the market”?
Activity 2
If a market is semi-strong form efficient, is it also weak-form efficient? Explain.

Activity 3

A stock market analyst is able to identify mispriced equities by comparing the average price for
the last 10 days with the average price for the last 60 days. If this is true, what do you know
about the market?

14.10 SUMMARY
1. There is a need to examine the alternative investment strategies both in terms of what
happens in practice and what should happen in theory on the basis of given assumptions
about investor’s behaviour.

2. The type of investment strategy to pursue will depend on how efficient securities markets
are.

3. It may be proved that if markets are efficient, trying to pick winners will be a waste to
time and effort. This is because in an efficient market, the prices of securities will reflect
the market’s best estimates of the expected risk and return, taking into account all that is
known about them.

4. There are 3 forms of market efficiency namely the weak form, the semi strong form and
the strong form.

5. The ability of a market player to earn profits or abnormal returns will decrease the greater
the degree of unit sophistication or the more efficient the market is.

6. Empirical findings are mixed as far as the testing of the EMH is concerned.

14.11 SUGGESTED READINGS

11
Unit 14
 DFA1035 Y Fundamentals of Finance and Practice

· Brealey R., Myers S., “Principles of Corporate Finance”, Latest edition

· Alexander G. J., Sharpe W. F. & Bailey J. V.,” Fundamentals of Investments, Latest
edition
· J. Rutterford ,1996, “Introduction to Stock Exchange Investment” Latest edition

14.12 USEFUL LINKS

For further reading, students are advised to consult the papers on the following links:
· https://www.princeton.edu/ceps/workingpapers/91malkiel.pdf
· http://m.e-m-h.org/ClJM.pdf
· http://web.mit.edu/Alo/www/Papers/EMH_Final.pdf
· http://eml.berkeley.edu/~craine/EconH195/Fall_14/webpage/Malkiel_Efficient%20Mkts.pdf

12
Unit 14