Wednesday, March 7, 2012

Efficient Securities Markets Theory

Elephant and blind wisemen is a story in which blind wisemen can touch only a part of the elephant and describe only what they sensed and fight among each other. Stock market is also a similar beast and many persons describe its price movements in different ways and give suggestions on how to make money from the market by being an active trader or a long-term investor. Efficient markets theory or hypothesis is in one of such explanations.

An efficient security market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security.

Efficient Market Hypothesis

The idea is that securities market is an informationally efficient market.

Why should a securities market be informationally efficient?

In the market large number of profit maximizing participants analyze and value securities, each independently of the others. 

New information comes to the market in a random fashion, and the timing of each piece of information is independent of others (New information, by definition, is information that was not known before, and it is not predictable). 

Profit maximizing traders or participants adjust security prices rapidly to reflect the effect of new information by trading actions in securities markets. It is important to note that this rapid price adjustment may be imperfect, but it is unbiased. Sometimes the market will overvalue the stock in relation to the information received and sometimes it may undervalue, but one cannot predict for any specific information whether market will overvalue or undervalue.  

It is the combined effect of information arrival to the market in a random fashion and trading actions of large number of traders to gain the profits made possible by the change in information, that price changes are independent, rapid, and random. 

In an efficient market, the expected returns implicit in the current price of the security should reflect its risk. 
In other words, we may say in terms of the capital asset pricing model; the expected return on the stock at the current market price is equal to risk free rate of return plus beta of the stock multiplied by market risk premium.

Subhypotheses of Efficient Market Hypothesis (EMH)

As the efficient market hypothesis states that capital market is an informationally efficient market, subhypotheses are created at various categories of information. 

The three categories for which hypotheses were developed by Fama are: 
1.     Security market information
2.     Public available information about the company, industry and economy
3.     All available information whether publicly announced or privately held.

Empirical Studies or Tests of EMH

Empirical Studies or Tests of Weak Form EMH

1. Serial Correlation Tests: Serial correlation between today's returns and return's of the previous day (or some past day) was calculated. The serial correlation was to be very low in many such studies. That shows that there is no relation between today's return and past returns.
2. Runs Tests: Some persons think that there are runs in stock price charts and they think they can be predicted. But runs test demonstrates the runs are themselves a phenomenon of random numbers or random distribution. The runs exhibited by stock prices is only a pattern exhibited by random series. Hence the runs in a stock price series cannot be predicted.

Originally posted on Knol efficient-securities-markets-theory Knol Number 151

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