The Conceptualization of Market Efficient Hypothesis
According to Jensen (1978), market efficiency with respect to information is such set without which it is not possible to make economic profits and this profit is gained by trading the information set. Despite the fact that capital market is efficient if is it fully reflected all the relevant information in determining the security prices. Similarly a market is efficient with the respect of information if security prices are unchanged by revealing that information to all participants. In addition, the efficiency of market with respect of information set results in gaining economic profits by using the set of information. However, the fact that fluctuation in stock market affects the efficiency of market, the understanding of market behavior enables the market to be efficient in terms of information (Miller& Vandome, 2009). That is given the information openly available at the time the investment is made as one is not able to constantly gain returns in excess of average market returns on a risk-adjusted basis. A market is asserted to be information efficient if prices fully reflect available information. A market is efficient with respect to information set if prices would be unchanged by revealing that information to all participants. It shows that it is impossible to make economic profits by trading on the basis of this information set. The market price of an efficient market changes when there is new and unexpected information. According to Ruppert (2004), price changes are unexpected therefore they change randomly. It is known that price does not change or market does not react to expected event because prices are already changed as a result of expected event as reaction. The best example of this situation is the stock price drop after 9/11 attacks. On the other hand, when US started bombing over Afghanistan, there was no market reaction because this event was expected by investors (Palan, 2007). Best assignment writing service
Forms of Hypothesis in Market Efficiency
Random walk is the theory associated with efficient market hypothesis and characterized with such price series where all following price changes demonstrate random departures from former prices (Sikorski, 1979). The conceptualization of random walk theory is that unhindered flow of information will be immediately reflected in stock prices and next day changed price will be reflected in next day news. Thus change of today affects the today’s price change but new definition of random walk is the unpredictability of market which results price change randomly and unpredictably. Thus, price reflects all information and uninformed investors by purchasing different portfolio provided by market can gain the return rate produced by experts. Market can be efficient even if there are some errors in the valuation and market can be efficient even if the market participants are irrational. The market can be efficient even if stock prices show greater instability that can be elaborated by preliminary earnings and dividends. Economics believe that there is efficiency related to market but on the other hand, market is such instrument that reflects the information immediately. Moreover, financial markets can be efficient as they do not involve the investors to find above-average risk-adjusted returns. In other words, it is believed that investment cannot be invested only for earning profit no matter who invest the money.
Efficient Market hypothesis is based on three forms of efficiency: weak form efficiency, semi strong efficiency, and strong form efficiency. Weak form of efficiency is the information set includes the history of prices and returns. Semi-strong efficiency is the information set includes all that information that is available publicly and strong-form efficiency is such set of information that includes all information that known to all market participants. Weak form of efficiency involves that the technical analysis will not make money. Semi-strong efficiency implies that fundamental analysis will not help the investors. The hypothesis of efficient market relies on certain assumptions such as many buyers and sellers, agents have rational expectations and on average make good decisions about buying shares/ stocks, and perfect information about market trends and profit of firms (Harder, 2010). According to the implications of efficient market hypothesis market is efficient in determining the price of financial securities, investors are likely to be rational and respond to events, it is difficult to outperform a market, and changed market prices are not capable of determining the future sock performance because market will not understand the event that possibly lead to lower profit market, buying and selling is easy because for example housing markets are not close to efficient market hypothesis with the fact that there is gap in buying and selling stamp duty. If it is assumed that efficient market hypothesis regulators require doing little to prevent the stock market bubbles. According to theory irrational price does not occur and if it does not occur then there is a much role for regulators to intervene in stock bubbles to prevent a boom. If such information or data is ignored by the investors then they have to go through changes and efficient investors are able to make profit out of minimizing the boom. To Cooper (2008), the market can be irrational for longer than investors’ solvency. Thus, this bubble can remain for a long time and the market position will fail before it makes benefit from the fall in price. With respect to rationality of market in response to irrationality of event, there is great contribution of human behavior influence on the economic because irrational nature of human behavior plays an important role in making economic decision. The experimental based evidence is that stock market price does not reflect and low price economic stock has greater returns.
However, it is fact that not every stock market follows the random walk model but the value that stocks outperformed (Fama& Miller, 1972). It is identified that stock market has temporary effect according to which stocks markets continue doing good in future if they have done good in past and cheap stock has greater risk than better stock market. Thus, if the hypothesis of efficient market is true then spending money on the research is illogical (Stiglitz, 2010). The theory of random walk declares that changing movement in price will not carry out any trend and past price change is not much useful to predict the future price change. Security market has many investors who are intelligent, well qualified with knowledge of market and overvalued securities to buy and sell. If there are more investors and the faster distribution of information, there would be efficiency in market. Custom dissertation writing service by UK expert
The Creation and Motivation of Efficient Market
Different empirical studies have been conducted to find if the markets are actually efficient and if they are efficient then what is the degree of this efficiency. The result of these studies have explored that efficient market hypothesis are more supported than other. Different test conducted to focus on the technical analysis of EMH. Efficient market hypothesis involve strategies that are useless in terms of predicting the security prices. The findings of these studies have also demonstrated the association of efficient market hypothesis with market anomaly though transactions costs can eliminate any advantage. There are other stock market anomalies that are contradictory to the efficient market efficient market hypothesis. The stock market anomalies which are based on the search for system can be utilized to outperform buyer strategy. After anomaly is found investors who try to misuse the inefficiency would consequence in disappearance. Many anomalies have been reported through back testing which have considerably disappeared to be difficult to exploit as a result of transaction costs.
The inconsistency of such efficient market is that if it is believed by every market participants that market is efficient then market no more remains efficient because no participant then focuses on the securities related to market prices. In making a market efficient there is great role of market participants and who believe that market is inefficient and trade securities in an attempt to outperform the market. It is a general belief that markets are neither completely efficient nor they are entirely inefficient. It can be supported that all markets are efficient to some extent and that some are inefficient similar to efficient. If there is considerable inefficiency observed in the efficiency of market for future, there will be more investors and participants to attempt to outperform the inefficient market. However, government bond market is considered as very efficient market, large capitalization stocks are also considered as efficient as small stock capitalization and international stocks are less efficient than large stock capitalization. Other markets like real estate is considered as less efficient as a result of lack of fluid and continuous markets; different participants can have different amounts and quality of information.
Efficient market hypothesis is also very important for making decision between active and passive investment. Active investment is argued that less efficient markets provide the opportunity to outperform using knowledgeable market. Nevertheless it is essential to realize that most of active investment in a specific market remains underperform the adequate benchmark in the long run whether markets are or are not efficient. It is fact that active investment and active management is a game of zero-sum and investors can profit on the basis of another less fortunate active investors to lose. However, with the increase cost addition marginally successful mangers can underperform. The efficiency of markets raises the question about role of investment professionals. Mostly it is believed that the rational of EMH gives the primary role of a portfolio manager to analyze and invest appropriately the market based on tax considerations of investors and risk profile. The most advantageous portfolio can differ according to different factors including risk aversion, employment, and tax bracket. Such role of mangers in the efficient markets is modified according to requirements and do not beat the market. Supporters of efficient market hypothesis do not favor the probability of beating the market and thus market can be divided into two different categories higher or lower expected returns in terms of risk factors. It is generally believed that cap stocks are riskier and it is expected that it gives higher return. In the same way, it is believed that value stocks are riskier than growth stocks and receive higher expected returns.
There are many active managers who believe that markets are not efficient with the perspective of deduction as it cannot add value. In the same way, media that is related to investment is generally considered to be unsure and uncertain about the efficient market hypothesis as they earn money by supplying the information to the market participant and they also realize that information is valuable for them. If information affects the market price, then investors and other market participants will not attempt to find the information for securities and markets. The outperformance by either one or more than one market participants and investors determine the inefficiency of market therefore it is more significant to identify the successful active managers and they should be evaluated in the context of all participants. In many cases it is difficult to determine if outperformance can contribute to the market efficiency. Commonly, markets share the expected efficiency based on probability and it is predictable that one market will experience sustainable and significant outperformance. The challenging task is to find that outperformance rather than just observing. The lack of consistency in performance can also lead to evidence in support of efficient market hypothesis.