Friday, February 6, 2009


The efficient market hypothesis.(EMH)

(1).Stock prices follow a random walk.

When researchers have examined stock prices movement for quoted companies they have observed that the price movements seem to follow a random pattern. In other words, stock price movements cannot be predicated.
From their observations, a hypothesis was developed which stated that stock prices are fairly valued on the basis of all existing information and stock prices quickly react to any new information. Being fairly valued means that expected returns equal required returns, taking into account the level of risk. This is referred to as an efficient capital market.
This would be expected given the large number of profit seeking investors analyzing stocks independently of one another. In may be referred to as the fair game model.

(2).Stock prices respond to new information .

Stock prices will move new when new information is received and will fairly reflect that new information since new information must, by definition, be unpredictable and random (otherwise it would not be new information) ,it follows that stock price movements will also be random. Stock prices adjust rapidly to new information according to the efficient market hypothesis (EMH).
This is referred to as informational efficiency.

(3). Assumptions underlying efficient capital markets.

The premises underlying the hypothesis that prices adjust rapidly to reflect all information are as follows,
  1. A large number of market participants are competing to analyze and value securities in order to make profits.

  2. Information comes to the market in a random fashion. Timing of an announcement is independent of other announcements.

  3. Competing investors quickly react to this new information in setting stock prices. The reaction may be imperfect, leading to an over or under-reaction to the new information. However there is no bias in one direction.

Generally, efficient capital markets therefore imply a minimum number of investors and a high degree of trading.

(4). The three forms of the EMH.
1. To what information do stock prices respond?Various levels of the EMH have been developed which state that markets take accounts of different levels. These are usually referred to as the weak. Semi strong and strong forms of the EMH.
2. Weak from of the EMH.The weak form of the EMH stats that all securities market information has already been incorporated into the current stock price. Market information includes share price movements, volumes, the nature of buyers and selves, etc.
What this implies is that it is impossible to use past stock price movements and other historic market information to predict future price movements.
This form of the EMH directly contradicts technical analysis assumptions implicitly, technical analysts believe that markets are not efficient, since they are using market information to make investment decisions.
3. Semi-strong from of the EMH.
The semi-strong form of the EMH stats that current stock prices not only reflect the market information referred to In the weak form but also rapidly move to incorporate any non market information that has been published about a company, i.e. the price reflects all public information.
For example, Release of preliminary figures by the company constitutes new information and the stock price will move to reflect this. Other public information is incorporated in ratios such as price to book value, P/E ratios. Ext.
This suggests that investors who base investment decisions on information after the information has been made public will not make excess returns on average.

4. Strong form of the EMH.The strong form of the EMH stats that, in addition to published information, a company’s stock price reflects all information that can be gleaned about the company itself, its markets and general economic factors. It includes those facts that are meant to be secret and confidential to the company itself.
Effectively, the strong form extends the efficient market to encompass the perfect market, where information is freely available to all investors at not cost and at the same time.
This form of the EMH is very extreme and few people actually believe that it applies in practice. The very fact that stock prices move when previously confidential information is published indicates that it is not the case.

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