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Efficient-market hypothesis - Wikipedia

An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximisers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

Learn the basics of the efficient market hypothesis

Before we consider whether financial markets are indeed efficient in the sense of offering fair prices, we need to look more closely at the definition of an efficient market. The best starting point for this is the concept, in general economic theory, of a perfectly competitive market (or perfect market for short). In a perfect market, there would be no barriers or even temporary delays to the formation of perfectly fair prices, that is, prices would instantaneously and universally reflect all available and relevant information. What conditions would have to be met in order to produce this ideal state of affairs? Here are the most important.

efficient market hypothesis - Investopedia

Fama identified three distinct levels (or ‘strengths’) at which a market might actually be efficient.

Observers of the random walk in share prices naturally sought to explain their findings in terms of the efficiency with which new information was incorporated into prices. They reasoned that if there were delays as new relevant information became disseminated through the market, the price of the affected share would not move instantaneously to the new equilibrium level reflecting the information, but would trend towards the new level over time. This might happen gradually or quite rapidly, but would still not be instantaneous. If this were the case then there would be periods (immediately following the release of new information) when price trends could be discerned. This in turn would mean that excess returns could be made, either by buying shares before the price had finished moving up to the new equilibrium level justified by good news, or by selling before the price had finished moving down to the new equilibrium level justified by bad news. The fact that these early studies found no such trends or correlations was seen as powerful support for the argument that the markets were efficient. It seemed to be the case that at any point in time, all available information was reflected in the price: the next move could not be predicted from the last one, as the next piece of news would not be genuine news if it was already implied in past prices. This finding was the central feature of what became known as the Efficient Markets Hypothesis (EMH) – the theory that the major stock markets, in particular those of the USA and UK, while not perfect, are at least efficient.

. Banz (1981), in a major study of long-term returns on US shares, was the first to systematically document what had been known anecdotally for some years – namely, that shares in companies with small market capitalisations (‘small caps’) tended to deliver higher returns than those of larger companies. Banz's work was followed by a series of broadly corroborative studies in the US, the UK and elsewhere. Strangely enough, the last twenty years of the twentieth century saw a sharp reversal of this trend, so that over the century as a whole the ‘small cap’ effect was much less marked. Whatever the reason or reasons for this phenomenon, clearly there was a discernible pattern or trend that persisted for far too long to be readily explained as a temporary distortion within the general context of EMH.

2 Perfect and efficient markets

Learn the aspects of the three forms of the efficient market hypothesis

If a market is semi-strong efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all publicly available information about the risk and return of an investment. The study of public information (and not just past prices) cannot yield consistent excess returns. This is a somewhat more controversial conclusion than that of the weak-form EMH, because it means that analysis – the systematic study of companies, sectors and the economy at large – cannot produce consistently higher returns than are justified by the risks involved. Such a finding calls into question the relevance and value of a large sector of the financial services industry, namely investment research and analysis.

If a market is weak-form efficient, there is no correlation between successive prices, so that excess returns cannot consistently be achieved through the study of past price movements. This kind of study is called or analysis, because it is based on the study of past price patterns without regard to any further background information.

Efficient Market Hypothesis - EMH | Financial Accounting …
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‘Efficient markets hypothesis ..

If a market is strong-form efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all relevant information, whether the information is in the public domain or not. As we have seen, this implies that excess returns cannot consistently be achieved even by trading on inside information. This does prompt the interesting observation that must be the first to trade on the inside information and hence make an excess return. Attractive as this line of reasoning may be in theory, it is unfortunately well-nigh impossible to test it in practice with any degree of academic rigour.

“Efficient market hypothesis is ..

In a slightly less rigorous form, the EMH says a market is efficient if all relevant information is quickly reflected in the market price. This is called the form of the EMH. If the strong form is theoretically the most compelling, then the semi-strong form perhaps appeals most to our common sense. It says that the market will quickly digest the publication of relevant new information by moving the price to a new equilibrium level that reflects the change in supply and demand caused by the emergence of that information. What it may lack in intellectual rigour, the semi-strong form of EMH certainly gains in empirical strength, as it is less difficult to test than the strong form.

An evaluation of the efficient market hypothesis

In its strongest form, the EMH says a market is efficient if all information relevant to the value of a share, whether or not generally available to existing or potential investors, is quickly and accurately reflected in the market price. For example, if the current market price is lower than the value justified by some piece of held information, the holders of that information will exploit the pricing anomaly by buying the shares. They will continue doing so until this excess demand for the shares has driven the price up to the level supported by their private information. At this point they will have no incentive to continue buying, so they will withdraw from the market and the price will stabilise at this new equilibrium level. This is called the of the EMH. It is the most satisfying and compelling form of EMH in a theoretical sense, but it suffers from one big drawback in practice. It is difficult to confirm empirically, as the necessary research would be unlikely to win the cooperation of the relevant section of the financial community – insider dealers.

Efficient market hypothesis in ..

earnings for ordinary shareholders Profit after deducting interest charges and taxation and after deducting preference dividends (but before deducting extraordinary items). earnings per share calculated as earnings for ordinary shareholders divided by the number of shares which have been issued by the company. effective interest rate The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument. efficient markets hypothesis Share prices in a stock market react immediately to the announcement of new information. endorsed International financial reporting standards approved for use in Member States of the European Union through a formal process of endorsement. endorsement See endorsed. enterprise a business activity or a commercial project. entity, entities Something that exists independently, such as a business which exists independently of the owner. entry price The value of entering into acquisition of an asset or liability, usually replacement cost. equities analyst A person who investigates and writes reports on ordinary share investments in companies (usually for the benefit of investors in shares). equity A description applied to the ordinary share capital of an entity. equity accounting Reports in the balance sheet the parent or group's share of the investment in the share capital and reserves of an associated company. equity interest See ownership interest. equity portfolio A collection of equity shares. equity shares Shares in a company which participate in sharing dividends and in sharing any surplus on winding up, after all liabilities have been met. eurobond market A market in which bonds are issued in the capital market of one country to a non-resident borrower from another country. exit price See exit value. exit value A method of valuing assets and liabilities based on selling prices, as an alternative to historical cost. expense An expense is caused by a transaction or event arising during the ordinary activities of the business which causes a decrease in the ownership interest. external reporting Reporting financial information to those users with a valid claim to receive it, but who are not allowed access to the day-to-day records of the business. external users (of financial statements) Users of financial statements who have a valid interest but are not permitted access to the day-to-day records of the company.

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