ECONOMICS,COMMERCE AND MANAGEMENT: EFFICIENT MARKET THEORY

EFFICIENT MARKET THEORY
SECURITY ANALYSIS AND PORTFOLIO MGMT/FUNDAMENTAL OF INVESTMENT
DR. SHASHI AGGARWAL

MEANING
SHARE PRICES FLUCTUATIONS ARE RANDOM AND DO NOT FOLLOW ANY REGULAR PATTERN.
DEVELOPED BY EUGENE FAMA IN 1960.
BASIC CONCEPTS:-

MARKET EFFICIENCY
OPERATIONAL EFFICIENCY
INFORMATIONAL EFFICIENCY
LIQUIDITY TRADERS
INFORMATION TRADERS

NO INVESTMENT STRATEGY BASED ON CURRENT OR HISTORICAL INFORMATION PRODUCES EXTRA ORDINARY LARGE PROFITS.
ASSUMPTIONS:

RATIONAL INVESTOR AND RISK AVERSE
NO TAXES AND NO TRANSACTION CHARGES
EFFICIENT AND COMPETITIVE STOCK MARKETS
CURRENT PRICE OF SHARE SHOWS ALL THE PUBLICALLY INFORMATION AND PRICE OF THE STOCK ADJUST RAPIDLY TO SHOW THE EFFECT OF NEW INFORMATION

THE RANDOM –WALK THEORY
BASED ON EFFICIENT MARKET HYPOTHESIS.
THREE FORMS:-

WEAK FORM
SEMI- STRONG FORM
STRONG FORM

WEAK FORM OF EFFICIENT MARKET HYPOTHESIS:-
CURRENT PRICES SHOWS ALL INFORMATION FOUND IN THE PAST PRICES AND TRADED VOLUME
NO PREDICTION OF FUTURE PRICES ON THE BASIS OF ANALYSIS OF PAST
LIQUIDITY TRADERS MAY SELL WITHOUT CONSIDERING THE INTRINSIC VALUE OF THE SHARES

WEAK FORM
DIAGRAM

· PAST PRICES DO NOT PROVIDE HELP IN GIVING INFORMATION ABOUT FUTURE PRICES.

· SHORT TERM TRADER MAY EARN POSITIVE RETURN. ON AN AVERAGE THEY WILL NOT OUT PERFORM THE BLIND FOLDED INVESTOR.

EMPIRICAL TESTS FOR WEAK FORM OF EMH
SERIAL CORELATION TEST
MEASURES THE CORELATION BETWEEN PRICE CHANGES IN CONSECUTIVE TIME PERIODS WHETHER HOURLY,DAILY OR WEEKLY.
MEASURES OF HOW MUCH THE PRICE CHANGES IN ANY PERIOD DEPENDS ON THE PRICE CHANGES OVER THE PREVIOUS PERIOD.
EXPLANATION
EXPLANATION
EXAMPLE
FORMULA
b=( ∑XY—n X‾Y‾)/ ∑X²-n ‾X²
a=Y‾-bX‾
r=(√a∑Y +b∑XY-n‾y)/ ∑Y²—n Y‾²

RUN TEST
MEANING
IS USED TO FIND OUT WHETHER THE SERIES OF PRICE MOVEMENTS HAVE OCCURRED BY CHANCE. A RUN IS AN UNINTERRUPTED SEQUENCE OF THE SAME OBSERVATION. IF A COIN IS TOSSED THE FOLLOWING SEQUENCE MAY OCCUR:-
HHTTTHHHTHH
MEANING
RUN TEST IGNORED THE ABSOLUTE VALUES OF NUMBERS IN THE SERIES AND TOOK INTO THE RESEARCH ONLY POSITIVE AND NEGATIVE SIGN. THE RUN TESTS ARE MADE BY COUNTING THE NUMBER OF CONSECUTIVE SIGNS OR RUNS IN THE OBSERVATION.
EXPLANATION
EXAMPLE
58,57,59,60,62,64,61,60,60,63,63,67,69
- + + + + - - 0 + 0 + +
+ =3
- =2
0=2
FORMULA
Z =R-X‾/ 
FILTER TEST
INVESTORS FIX A FILTER LEVEL RANGING FROM 0.05 % TO 5% OF CURRENT STOCK PRICE.
IF STOCK PRICE RISES AND TOUCHES TO 5% OF BASE LEVEL IN UPWARD DIRECTION HE WILL BUY BUT IF STOCK PRICE FALLS AND TOUCHES TO 5% OF BASE LEVEL IN DOWN WARD DIRECTION, SELL THE STOCK PRICE.
EFFICIENT MARKET THEORY ( SEMI STRONG FIRM)
HYPOTHESIS STATES THAT SECURITY PRICES ADJUST RAPIDLY TO ALL PUBLICLY AVAILABLE INFORMATION.
THE PRICES NOT ONLY SHOW THE PAST PRICE DATA BUT ALSO THE AVAILBLE INFORMATION REGARDING THE EARNINGS OF THE CORPORATE,DIVIDEND,BONUS ISSUE,RIGHT ISSUE,MERGERS,ACQUISITIONS AND SO ON.
ONLY PROFIT EARNED BY THE INSIDERS IN SHORT RUN.
THE INTRINSIC VALUE AND EQUILIBIRUM PRICES ARE THE SAME
EMPIRICAL EVIDENCE
MARKET REACTION TEST
EMPIRICALLY TESTED BY FAMA,FISCHER,JENSEN AND ROLL. THEY ANALYSED THE EFFECT OF STOCK SPLIT ON SHARE PRICES.
SHOWED THAT STOCK SPLITS INFORMATION BROUGHT IN THE MARKET REACTION JUST BEFORE THE SPLIT ANNOUCEMENT. SHOWED THE RETURN WAS FAR ABOVE THE NORMAL RETURN BY THE LONG TERM INVESTOR BY BUYING AND HOLDING STRATEGY.
MARKET REACTION TEST
1N 1972,SCHOLES CONDUCTED A STUDY TO OBSERVE,” THE REACTION OF SECURITY PRICES TO THE OFFER OF SECONDARY STOCK ISSUES. PRICE OF SECURITY DECREASES WHEN THE ISSUER WAS A COMPANY WHICH INDICATED TO THE MARKET THAT SUCH AN OFFER CONTAINED SOME BAD KNOWS.
BUT SECONDARY OFFERINGS NOT VIEWED IN A NEGATIVE MANNER.
MARKET REACTION TEST
KRAUS AND STOLL CONDUCTED A STUDY TO EXAMINE” THE EFFECT OF LARGE BLOCK TRADES ON THE BEHAVIOUR OF SECURITY PRICES” WHICH SHOWED THE TEMPORARY EFFECT ON SHARES PRICE WHICH WERE ASSOCIATED WITH BLOCK TRADE.
BEAVER STUDIED THE IMPACT OF ANNOUCMENTS OF ANNUAL EARNINGS AND THE SPEED OF CHANGES. EXAMINED THE LEVEL OF TRADING VOLUME AND SIZE OF PRICE CHANGES. ABSOLUTE VALUES OF PRICE CHANGES AND LEVEL OF TRADING WAS SIGNIFICANTLY HIGHER DURING THE ANNOUCMENT WEEK.
EMPIRICAL EVIDENCS
MARKET INEFFICIENCIES
LOW PE EFFECT
SMALL FIRM EFFECT
THE WEEKEND EFFECT
STRONG FORM
ALL INFORMATION IS FULLY REFLECTED ON STOCK PRICES. REPRESENT AN EXTREME HYPOTHESIS WHICH MOST OBSERVERS DO NOT EXPECT IT TO BE LITERALLY TRUE.
NOT ONLY THE PUBLIC AVIALBLE INFORMATION BUT ALL INFORMATION IS USELESS TO INVESTORS.
CAN NOT BE USED TO CONSISTENLY TO EARN SUPERIOR RETURN.
EMPIRICAL EVIDENCE
DEAL WITH MUTUAL FUND PERFORMANCE
FINANCIAL ANALYSIS HAVE STUDIED THE RISK ADJUSTED RATE OF RETURN FROM HUNDREDS OF MUTUAL FUNDS AND FOUND OUT THAT THE PROFESSIONALLY MANAGED FUNDS ARE NOT ABLE TO OUTPERFORM THE NAÏVE –BUY AND HOLD STRATEGY.
DIFFERENT INVESTMENT GROUPS:-

CORPORATE INSIDERS
STOCK EXCHANGE SPECIALSITS
PROFESSIONAL MONEY MANAGERS

THE ESSENCE OF THE THEORY

THE RANDOM WALK HYPOTHESIS DEALS WITH THE ABSOLUTE PRICE CHANGES AND NOT WITH RELATIVE CHANGES.
MAINLY DEALS WITH THE SUCCESSIVE CHANGES RATHER THAN PRICE OR RETURNS
ENTIRELY CONSISTENT WITH THE UPWARD AND DOWNWARD MOVMENTS OF THE STOCK PRICE.
THE EQUILIBIRUM RETURN IS DEFINED AS THE RETURN EARNED BY THE NAÏVE BUY AND HOLD STRATEGY.
LINK FOR OTHERS TOPICS RELATED TO INVESTMENT MANAGEMENT :'
1. FUNDAMENTAL OF INVESMENT