EFFICIENT MARKET THEORY

I. EFFICIENT MARKET THEORY

DEFINITION

Efficient Market Theory states that the prices

of securities traded on a market at all times
“properly reflect” all information that is
publicly known about those securities.

Market where all pertinent information is

available to all participants at the same time,
and where prices respond immediately to
available information
FEATURES/ CONCEPT OF EMT
• A perfectly competitive market, operates in an
efficient manner to bring about actual stock prices
• Investors have free access to the same
information so that the market prices reflect the
stocks present value
• Stock value based on demand & supply
• Any deviation from this is quickly corrected and
stocks come back to the equilibrium price
• Price change occurs in the stock only because of
changes that affect the company or the stock
market
FEATURES
•The change in price alters the stock prices
immediately & sets a new equilibrium level
• This rapid shift to a new equilibrium level
whenever new information is received is the
Random Walk Theory
• The instant adjustment shows that all information
known is reflected in the stock price
• Further change will be due to some other new
information
• Changes in price show independent behaviour
(each information is new)
II. RANDOM WALK THEORY

• This theory gained popularity in 1973 when

Burton Malkiel wrote "A Random Walk Down
Wall Street", a book that is now regarded as an
investment classic.
•Random walk is a stock market theory that states
that the past movement of the price of a stock or
overall market cannot be used to predict its future
movement
• Stocks take a random and unpredictable path.
•The chance of a stock's future price going up is
the same as it is going down
RANDOM WALK THEORY

• Stock prices change randomly, making it

impossible to predict stock prices.

•The random walk theory believes that markets

are efficient, and that it is not possible to predict
the market because stock prices reflect all
available information and the occurrence of new
information is seemingly random as well.
III. Efficient Market Hypothesis (EMH)
• The EMH was developed by Professor Eugene
Fama
•A theory that states that a share’s prices fully
reflect all available information. The EMH argues
that stock prices incorporate relevant market
information arriving at fair prices

• There are three variants of the hypothesis:

"weak", "semi-strong", and "strong" form.
•The less information there is, the weaker EMH is,
and the more information there is, the stronger
the EMH is.
Efficient Market Hypothesis (EMH)
• The weak form of the EMH claims that only past
information is reflected in current prices of stock
and cannot predict future stock prices

•The semi-strong form of the EMH claims that

prices reflect both past information and all
publicly available information and that prices
instantly change to reflect new public information.

•The strong form of the EMH additionally claims

that prices instantly reflect even hidden "insider"
information.
EMPIRICAL ANALYSIS – Empirical
studies are the collection and analysis of
primary data based on direct observation
or experiences in the 'field'. Several
Empirical tests have been undertaken on
EMT

A. Research on Weak Form of Market

States that no investor can use past
information to earn returns. Technical
Analysis will not be indicative of superior
portfolio performance
1. Random Walk Test

• Researchers studied whether “security

prices follow a random path”
• Changes in security prices on a day are
independent of prices prior to that day
• Direction of price change cannot be
predicted
2. Behaviour of Commodity Prices

• Research first conducted by Bachelier

in 1900.
• Research showed that commodity
followed a random walk
• Gold, Silver, Crude oil
Gold Price/oz Gold
Price/gram
07/28/15 69,913.78 2,247.78
07/29/15 70,416.71 2,263.95
07/30/15 69,743.09 2,242.29
07/31/15 70,026.70 2,251.41
3. Simulation Test
• Research conducted by Roberts &
Osborne in 1959.
• Roberts took the DJIA and compared its
level with a variable generated by a
random walk mechanism.
• He concluded that the mechanism of the
random walk showed patterns which
were very similar to the movements of
stock prices.
The Dow Jones Industrial Average (DJIA)
is a price-weighted average of 30
significant stocks traded on the New York
Stock Exchange (NYSE) and the
NASDAQ (National Association of Securities
Dealers Automated Quotations)

• The DJIA was invented by
Charles Dow back in 1896.
4. Brownian Motion Test

•Osborne’s research showed that stock

prices moved similar to Brownian Motion.

Brownian Motion is the erratic random

movement of microscopic particles in a
fluid, as a result of continuous
bombardment from molecules of the
surrounding medium.
Brownian Motion Test

• According to Osborne’s research, the

security prices move constantly with the
Brownian Motion Model which showed
that the price changes in one period were
independent of the price changes in the
previous period.
5. Serial Correlation Test
• Many more researches tried to test if
security prices follow a random walk.
•In 1964, Moore took up a test called
‘Serial Correlation Test’.
• Moore measured correlation of price
change of one week with the price change
of the next week.
• Found that a price rise did not show the
tendency to follow the price fall or vice
versa
6. Fama Serial Correlation Test
• Fama also tested the Serial Correlation of
daily price changes in 1965.
•He studied the correlation for 30 firms which
composed of the DJIA for five years before
1962.
•His research showed an average correlation of
-0.03.
•This correlation was also weak because it was
not very far away from zero and, therefore, it
could not indicate any correlation between
price changes in successive periods.
7. Run Test
• Run Test was also made by Fama to find
out if price changes were likely to be
followed by further price changes of the
same sign.
• The Run Tests are made by counting the
number of consecutive signs or “Runs” in
the same direction.
• No difference which was significant was
observed while making this test.
B. Research on Semi Strong Form of
Market
According to the Semi-Strong Form of the
market, the security prices reflect all
publicly available information.

In this state, the market reflects even those

information like the announcement of a
firm’s most recent earnings forecast and
adjustments which will have taken place
in the prices of security.
1. Market Reaction Test

• The research study showed that the stock

splits information brought in market reaction
just before the split announcement.

•Markets react positively to stock splits

In June 2014, Apple Inc. split its shares seven-for-one in order

to make its shares more accessible to a larger number of
investors. Right before the split, each share's opening price
was approximately $649.88. After the split, the price per share
at market open was $92.70 (648.90 / 7).
2. Announcement Effects

•Beaver examined the level of the trading volume

and the size of price changes.

• the values of price changes and levels of trading

was significantly higher during the announcement
week.

•In the week following the announcement week, it

returned to pre-announcement levels.
3. Price Change Test

In 1972, Scholes conducted a study to

observe “the reaction of security prices to
the offer of secondary stock issues.”

The research studies showed that the price

of security decreases when the issuer was a
company which indicated to the market
that such an offer contained some bad
news.
Price Change Test

But secondary offerings by investor, banks

and insurance companies were not viewed
in a negative manner and the security
prices did not significantly fall.
4. Effect of Large Trade on Prices

•Kraus and Stoll

• Studied the effect of large block trades on
security prices
•Showed a decrease in price but the price
rose almost immediately
• No reaction in prices the following day
B. Research on Strong Form of Market
•In the strong form of the market, all information
is represented in the security prices in such a way
that there is no opportunity for any person to
make an extraordinary gain on the basis of any
information.

•This is the most extreme form of the efficient

market hypothesis.

•Most of the research work has indicated that

the efficient market hypothesis in the strongest
form does not hold good.
1. Collins Test

•In 1975, Collins tested the strong form of

the market.

•Collins showed that the consolidated

earnings of a multi-product firm could be
accurately predicted by using segment and
profit data rather than by using
consolidated historical earnings data.
2. Mutual Fund Performance
•The performance of mutual funds have
been tested by Friend in 1972, by Sharpe in
1966 and by Jensen in 1969.

•The hypothesis was “that the mutual funds

could earn extraordinary return and
constantly achieve a higher than average
performance because they are likely to
have excess inside information which is not
otherwise publicly known”.
2. Mutual Fund Performance

•The research study showed that the

mutual funds were not better in
performance than an individual investor
who purchases the same securities with the
same risk.
Random Walk Model Conclusions

• Successive price changes are independent

• Historical information about price changes alone
will be useless for making a gain
• In addition to past prices, investors need other
relevant information
• Random Walk Model does not believe in Technical
Analysis
• Random Walk Model supports Fundamental
Analysis