The Efficient Markets Hypothesis (EMH)

Market Efficiency

The concept of market efficiency was first developed in the finance literature and its full form was first explained by Engene Fama. But now-a-days this concept is being used in other areas also. Market efficiency implies that prices reflect all available information, but it does not imply certain knowledge.  Many pieces of information that are available and reflected in prices are fairly uncertain.  Efficiency of markets does not eliminate that uncertainty and therefore does not imply perfect forecasting ability. By definition then there should not exist any unexplained opportunities for profit.

“An ‘efficient’ market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.” – Eugene F. Fama, “Random Walks in Stock Market Prices,” Financial Analysts Journal, September/October 1965 (reprinted January-February 1995).

The definition of efficient market is a little vague and its vagueness it seems, is intentional.  It can be shown that, under certain circumstances, it is not required all market operators to share exactly identical views on the future price.  Some investors may be better informed than others.

Market efficiency implies that market participants are rational.  Rational people will immediately act upon new information and will bid prices up or down to reflect that information.

“Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are – plausibly enough – the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence.” – Robert C. Higgins, Analysis for Financial Management (3rd edition 1992)

Efficient Markets Hypothesis (EMH)

The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information.  If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information.

  1. The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume.  This version of the hypothesis implies that trend analysis is fruitless. Past stock price data are publicly available and virtually costless to obtain. The weak-form hypothesis holds that if such data ever conveyed reliable signals about future performance, all investors already would have learned to exploit the signals. Ultimately, the signals lose their value as they become widely known because a buy signal, for instance, would result in an immediate price increase. To conclude, investors are unable to earn abnormal returns using historical prices to predict future price movements.
  2. The semistrong form states that a firm’s stock price reflects all publicly available information about a firm’s prospects. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Again, if investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices. To conclude, investors with insider, or private information, are able to earn abnormal returns.
  3. The strong form of the EMH holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm. To conclude, investors are unable to earn abnormal returns using insider information or historical prices to predict future price movements.

The implications of the efficient market hypothesis are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

Implications Efficient Market Hypothesis (EMH) in Stock Analysis

In efficient markets, the current prices of stocks already reflect all known relevant information.  In this situation, growth stocks and value stocks provide the same risk-adjusted expected return.

  1. Technical analysis of stocks involves the search for recurrent and predictable patterns in stock prices in order to enhance returns.  The EMH implies that technical analysis is without value.  If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule.
  2. Fundamental analysis of stocks uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices.  The EMH predicts that most fundamental analysis is doomed to failure.  According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information.  Only analysts with unique insight achieve superior returns.

In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes.

Implications Efficient Market Hypothesis (EMH) in Forex Markets

The implication of the concept of market efficiency in forex market is interesting.  Let us assume that both spot and forward markets of a currency are characterized by the following condition: (a) There are a large number of investors with ample funds available for arbitrage operations, and (b) There are not exchange controls and also no transaction costs.

In this situation suppose an American investors thinks that spot price of deutsche mark (DM) in terms of the dollar is going to be 15 per cent higher in twelve months than it is to day.  The investor may be able to profit by buying DM forward, and then selling DM spot at the end of 12 months.  If his judgment proves right, his profit will be 15 per cent less the premium paid for forward DM (transaction cost is nil as assumed).  As the market information is perfect, other investors will follow suit, and the forward DM will be bid up until the premium is high enough to prevent any further speculation.

One interesting question is: how long will the speculation continue in the market to have a share of the profit. This is not indefinite, as at some point investors will realize that, although the potential of profit from speculation is not zero, the probable reward is not great enough to compensate for the risk of being wrong.  Thus equilibrium will be reached and speculation will spot at the point where the gap between the forward rate and the expectation of the market of the future spot rate is just equal to the required risk premium charged, or in equation it becomes

Ft (t+1) = Et(St+1) + rt

Where LHS is the logarithm of forward price of DM at time t for delivery at period (t+1) and rt is the risk premium.  In the above equation the forward rate reflects both the publicly available information congealed in the rational expectation Et(St+1) and the attitude of the market towards risk revealed in the risk premium.  Thus the equation shows the equilibrium in the efficient market.  The interpretation of efficiency explained here corresponds to what E.  Fama called semi-strong form of efficiency (FAMA, 1970).  Strong form of efficiency applies when the market price reflects all information, whether publicly available or not.

It is quite possible to imagine a situation where the market price reflects only the restricted information set which can be used in the formation of weakly rational expectations.  Here the expected value in the equation would be conditioned on the past value of the time series, and not on the universe of publicly available information.  This helps in defining a weakly efficient market.

A weakly efficient market is one where the market price reflects the market information in its own past history.  It implies that there no longer exists any opportunity to profit by making use of past time series of prices alone. One interesting aspect of weakly efficient market is that there will normally remain opportunities to make a profit by the exploitation of information additional to the past time series of prices.  Another implication of market efficiency is the unbiasedness of the market.

A forex market is said to be unbiased when the forward market is efficient and investors are risk neutral, so that the forward rate is equal to the mathematical expectation of the spot rate at the time of the maturation of the contract.

Efficient of inefficient players in the forex market are big and they are equipped with very powerful computers with dedicated software.  In spite of the fact that they have access to massive data set and powerful software, calculations go wrong and survey data repeatedly point out irrational movement of expectations.  May be this is another mystery of the market forces.

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