Literature Review

2.0 Introduction

In order to better understand the origin and the idea behind the Efficient Market Hypothesis (EMH), the first section deals with an overview of the EMH. Section 2 deals with the Random Walk Model which is a close counterpart of the EMH. We then have examine the different degrees of information efficiency that exist, namely the weak form efficiency, semi-strong form efficiency and the strong form efficiency. In section 4, we have a brief overview of the different types of statistical tests that have been used in the literature to examine the weak form efficiency. Section 5 explains the implications of efficient markets for investors. Section 6……………………..

2.1 Efficient Market Hypothesis (EMH)

The concept of efficiency is one of the essential concepts in finance. Market efficiency is a term used in many different contexts with many different meanings. Market efficiency involves three related concepts- allocation efficiency, operational efficiency and informational efficiency.

Allocation efficiency: A characteristic of an efficient market in which capital is allocated in a way that benefits all  participants. It occurs when organizations in the public and private sectors can obtain funding for the projects that will be the most profitable, thereby promoting economic growth

Operational efficiency: A market condition that exists when participants can execute transactions and receive services at a price that fairly equates to the actual costs required to provide them. Economists use this term to describe the way resources are employed to facilitate the operation of the market. It is usually desirable that markets carry out their operations at as low a cost as possible.

Information efficiency: The actual market price of a share should reflect its intrinsic value. Information efficiency implies that the observed market price of a security reflect all information relevant to the pricing of the security. The investor can manage to earn merely a risk-adjusted return from his investment, as prices move instantaneously and in an unbiased manner to any news.

The efficiency in the market for financial assets and assets returns refers here to the information efficiency and should not be confused with the other types of efficiency.

As explained by Rahman and Hossain (2006):

For a stock market to be efficient, stock prices must always fully reflect all relevant and available information. This definition can be expressed as ƒ(Ri,t, Rj,t … … … | φM t-1) = ƒ( Ri,t, Rj,t … … … | φM t-1, φa t-1), where ƒ(.) = a probability distribution function, Ri,t = the return on security i in period t, φM t-1 = the information set used by the market at t – 1, φa

t-1 = the specific information item placed in the public domain at t – 1. This equation has two important implications.

Specific information item at t-1 (φa t-1) cannot be used to earn non zero abnormal return.

When a new information item is added to the information set φM, it is instantaneously reflected on market prices.

The concept of market efficiency was first introduced by Bachelier (1900). Since then, there has been many studies like Working (1934), Cowles and Jones (1937), Kendall (1953), Cootner (1964). However it was Fama (1965) who first used termed it as “efficient market”. Fama (1970) later stated the sufficient but not necessary conditions for efficiency:

there are no transaction costs in trading securities;

all available information is costlessly available to all market participants, and

all agree on the implications of current information for the current price and distributions of future prices of each security

He also identified three degrees of informational efficiency namely the weak form, the semi-strong form and the strong form.

2.2 Random Walk Model (RWM)

The Random Walk Model is a close counterpart of the Efficient Market Hypothesis. The model was originally examined by Kendall (1953). It states that stock price fluctuations are independent of each other and have the same probability distribution. Thus the Random Walk theory suggests that stock price change randomly, making it impossible to predict stock prices. The Random Walk Model is linked to the belief that markets are efficient and that investors cannot beat or predict the market because stock prices reflect all available information and the new information arises randomly. As mentioned in Fama (1970) the two hypotheses constituting the Random Walk Model , that is (i) successive price changes are independent and (ii) successive changes are identically distributed, are implicitly assumed in the Efficient Market Hypothesis.

The Random Walk Model is in direct opposition to technical analysis, which suggests that a stock’s future price can be forecasted based on historical information through observing chart patterns and technical indicators.

2.3 3 Forms of Market Efficiency

2.3.1 Weak-Form Efficiency