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Efficient markets theory

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Efficient markets theory is a field of economics which seeks to explain the workings of capital markets such as the stock market. In an efficient market, the prices of stocks reflect a rational assessment of the true underlying worth of a stock. This can be contrasted with an inefficient market in which prices might be affected by other factors such as fashion, greed, panic and stock market bubbles.

A central part of this theory is the efficient market hypothesis. In general, the efficient market hypothesis implies that it is not generally possible to make above average returns on the stock market, except through luck or holding inside information. There are three common forms in which the efficient markets hypothesis is commonly stated - weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work.

Weak-from efficiency

  • No excess returns can be earned by utilising investment strategies based on historical share prices or other financial data.
  • To test for weak-from efficiency it is sufficient to use statistical investigations on time series data of share prices. In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. The only factor that affects these prices is the introduction of previously unknown news. However, by definition news occurs randomly so share price changes must also therefore be random.

Semi strong-form efficiency

  • Share prices adjust instantaneously and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information.
  • To test for semi strong-form efficiency the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient way.

Strong-from efficiency

  • Share prices reflect all information and no one can earn excess returns.
  • To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. When the topic of insider trading is introduced (Where an investor trades on information that is not yet publicly available) the idea of a strong-form efficient market seems impossible. Studies on the US stock market have shown that people do trade on inside information. It was also found though that others monitored their activity and in turn followed, having the effect of reducing any profits that could be made.
  • If there are fund managers who have consistently beaten the market, then it cannot be described as being strong-form efficient. Common sense and empirical evidence suggest that stock markets are unlikely to be strong form efficient.

Arguments concerning the validity of the hypothesis

Many economists dispute the assumption that market participants are rational, or that markets behave consistently with the efficient market hypothesis, especially in its stronger forms. The efficient market hypothesis was introduced in the late 1960s and the prevailing view prior to then was that markets were inefficient. Economists and mathematician alike could not believe that a manmade market could be efficient when it depended upon human input, which at times cannot be described as being rational. Much inefficiency was found in the US and UK stock markets, and some economists continue to reject the hypothesis even in its weakest form.

However, earlier work by Kendall (1953) found that changes in UK market prices were indeed random. It was not until twenty years later that Brealey and Dryden, and also Cunningham found that there were no significant dependences in price changes proving that the UK stock market was weak-form efficient.

For example, market anomalies such as the Asian crash in the 1998 and the major World wide stock market crash in October 1987 where diverse stock exchanges such as Norway and Singapore all crashed at the same time highlight problems with worldwide stock exchanges. Abnormal trading patterns occurred with mass panic selling causing a huge drop in the value of shares - which, especially after the 1998 crash all recovery to the previous selling price in some cases even higher.

Opponents of this theory say that there are trading rules that can be used to earn excess return from the market. However the people who suggest this will not disclose the rues and they cannot be independently checked. The overwhelming conclusion is that the UK stock market is at least weak-form efficient.

Further to this conclusion that the UK stock market is at least weak form efficient, other previous studies of capital markets have found them to be semi strong-form efficient. Studies by Firth (1976, 1979 and 1980) in the UK have compared the share prices existing after a take over announcement with the bid offer. He found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi strong-form efficient.

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