PART 2 – EFFICIENCY MARKET HYPOTHESIS

Introduction

In order to better understand the origin and the idea behind the Efficient Market Hypothesis (EMH), an overview of the EMH, The Random Walk Model, different degrees of information efficiency and the implications of efficient markets for investors are studied in the paper.

Efficient Market Hypothesis

The efficiency concept is one of the most essential concepts for investment management and analysis. Market efficiency basically revolves around three related assumptions on proper- allocation efficiency, informational efficiency and operational efficiency.

Efficiency in allocation is a vital characteristic of a strong market wherein the allocation of capital is done in a proper way so that it benefits all the participants and helps in promotion of economic growth and status.

Efficiency in operation is another crucial parameter which is used commonly by economists to determine and analyzes how resources are utilized in the market to benefit operational activities in the market and industry.

Efficiency in information helps to determine the actual market value of shares based on its intrinsic value. The Information efficiency signifies that reflection on all available information pertaining to the security’s price must be used to determine the security’s observed market price. (Hossain,Rahman, 2006)

The introduction to the idea of market efficiency was given by Bachelier (1900) and later it was termed as efficient market by Fama (1965)

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Fama (1970) further went on to state the vital conditions/ assumptions for maintaining efficiency:

1. Provision of no transactional costs during the trading of securities;
2. All information is freely available to all the participants in the market, and
3. Agreement of all of them on the implications of the information relating to the current price and future distribution of prices of each security

He identified three forms of informational efficiency, which are the weak form(underdeveloped), the semi-strong form(developing) and the strong form efficiency(developed).

Forms of Market Efficiency

Weak-Form Efficiency

Weak form efficiency market implies that it is an efficient market which reflects all its market information accurately and does not provide profit for the investor based on past records or rates. This past records stands invalid for the market. Fama (1970) stipulates in his theory that no investor can avail greater returns when the market is weak-form efficient. Example African economy has a weak efficiency market wherein the means to attain gains on investment is narrow based on past investment experience. Example trading test, auto correlation test and run test.

Semi-Strong Form Efficiency

Semi Strong Form Efficiency market indicates that market is efficient and it reflects all public information. It says that the stocks are absorbant of all new information and incorporates it by adjusting to it. It is partly like the weak form efficiency market wherein the stocks rate are based upon new information that is released after the stocks are bought. So making it difficult for the market to be predictable. Fama (1970) explains the semi-strong form efficient market as the one where share price not only reflect on all information regarding its past and historic prices, but also includes additional public information which is later on integrated with the shared price and adjusted to reveal the true share value. This also implies that an investor will not be able to use the public information for the generation of gains in the evolving stock market. Event tests and time series/ regression tests are some examples.