Introduction In the book Corporate finance by Denial Watson and Antonym Head (2001), Watson et al refers to a work by Dixon and Holmes (1992) which suggests that the transaction costs ought to be as diminutive as probable to allow for the minimization of entrances to trading in capital markets and operational efficiency is encouraged. Fame (1970) describes market efficiency hypothesis as “the price of a security fully and fairly reflects all available and relevant information” (Mutual, 2013). The efficient market hypothesis has dominated both the academic and business environment since the publication of Fame’s classic exposition in 1970.
The matter under intense scrutiny is whether it is possible to exploit market inefficiencies to consistently making abnormal returns by trading in the shares using biblically available information The weak efficiency form postulates that future stock prices cannot be predicted from historical information about prices and returns” (Begs, 2013) but rather that asset prices follow a random walk and that any information that could be employed to forecast future prices is autonomous of past prices.
Evidence supporting weak efficiency form In order to test the weak efficiency form hypothesis, a degree of theories need to be set up. The Random walks theory is one of the less demanding theories which put forth the notion that “the future path of the price level of a security is no more eradicable than the path of a series of cumulated random numbers” (Economic, 1994). In arithmetical terminology this simply means that consecutive price changes are independent of the direction of the price changes of another day, identically distributed random variables (Economic, 1994).
Fame (1965), postulated that the past cannot be employed as the forecaster of the future in a significant way but that the distribution of price changes was originate on the basis of utter fortune. The random walk model could be viewed as a limiting version of the weak efficiency form of the efficient market hypothesis. This means that if the random walk efficiency theory holds, the weak form of the efficient market hypothesis must also hold but the opposite won’t hold. Therefore, evidence supporting the random walk model is evidence supporting weak form efficiency.
Kendall (1953) carried out one of the earliest studies for testing serial correlation, where he looked for any correlation between the price changes of securities at different points in time ( Watson, 2001). Alexandra (1961) compiled filter tests, which are aimed at identifying long-term relationships in security price movements by separating out short-term price changes. He established that the filter test could provide abnormal returns in contrast to a straightforward buy and hold approach because any returns gained were cancelled out when transaction costs were taken into account.
Evidence against weak efficiency form It is impossible to attain abnormal risk adjusted returns by employing precedent prices or volume data to foresee future stock prices. Technical analysts denote the idea that the stock market is weak form efficient but more accurately deem investors emotionally driven and predictable. Thus this predictability could be exploited as it shows up in historical prices and volume. Furthermore, financial analysts argue that ten tests AT weak inclemency Tort Limit ten trading rules to tense Dates on analytical price changes in stock price.
If there were patterns or serial correlations in the stock price changes, founded on historical figures, then investors could source their purchasing and distribution on such patterns but the efficient market approach states if such patterns existed then the large number of financial analysts would quickly identify the pattern and their trading of stock would eradicate that pattern. “The semi-strong efficiency form suggests that stock prices react almost immediately o any new public information about an asset” (Begs, 2013).
It puts forward the notion that the market will quickly process the publication of relevant new information moving from price to a new equilibrium level that exhibits the change in supply and demand caused by the metallization of that information. Evidence supporting semi-strong efficiency form Tests for semi-strong efficiency form investigate the speed and accuracy of price movements because the information had already been considerably integrated into security prices.
The aim is to ascertain whether it is achievable to make profits from sews information that is publicly available; more especially establish financial news concerning to a particular company. The thinking is that if prices adjust rapidly to news, the market is then considered efficient and there is no range for trading profits following the news (Redhead, 2003). If stock prices alter gradually there is an prospect for determining, and trading upon, the direction of price change. Slow price changes indicate market inefficiency.
The well known research study by Ball and Brown (1968) demonstrated that it is highly unlikely to attain profits on the grounds of earnings announcements. It “investigated the usefulness of earning published in company accounts from the point of view of making trading profits” (Redhead, 2013). Ball and Brown used a sample of companies which they separated into two groups; earnings that exceeded expectations and the other with disappointing earnings. In both groups, a majority of the earnings announcement as information developed steadily available through interim reports, brokers, analyses and newspaper articles.
The information previously unknown was determined to be incorporated into the share price almost immediately after earnings announcement. Correspondingly an analysis by Shown and Pinker (1981) illustrated that it is not viable to achieve abnormal returns on the foundation of announcement concerning mergers “A stock split is a corporate action that increases the number of the corporation’s outstanding shares by dividing each share, which in turn diminishes its price” (Investigated, 2010), they do not add anything to the value of a company and also should have no effect on the full value amount of shares outstanding.
Nevertheless, the stock splits might transmit information about future cash flows. Fame, Fisher, Jensen and Roll (1969) examined the potential for gaining profits from sews about stock splits. This study conjectured that the announcements of available stock splits produced expectation of excessive future dividends. The findings revealed that after the split the businesses that rose dividends experienced stock price increase while those that failed to meet expectation of higher dividends rapidly after the announcements of the stock splits, “and the price rise was subsequently AAA to or removed dependent upon wiener realized” (Redhead, 2003).
Evidence against semi-strong efficiency form ten Loveland expectations were Whilst there is evidence supporting the semi-strong efficiency form suggests that early tests of price immediate reaction to earnings announcements that price changes were completed quite rapidly, more studies conducted disputed these findings by suggesting that a portion of the price response is subject to considerable lag time. It is impossible to make abnormal risk-adjusted returns by analyzing any public information to predict future stock prices.
Fundamental analyst do not this the stock market is semi-strong efficient. They use publicly available information to identify firms that are worth more or worth less than everyone else’s estimate of their values. ‘V. Strong efficiency form Markets are said to be strong form efficient if share prices reflect all information, whether it is publicly available or not” (Watson, 2001). This form claims that if the markets are strong form efficient then even investors with private information that the public does not have access to cannot attain abnormal gains.
Evidence supporting strong form efficiency Tests that focus on the investment performance of mutual funds are more likely to generate an abnormal profit, which means that it supports the strong form efficiency. These tests hypothesize that managers are more likely to gain access to private information and have a better opportunity to retrieve the effects of the information on the stock earnings. Thus, if after accounting for the level of risk this entails, certain funds can consistently attain abnormal profits.
Evidence against strong form efficiency Technical analysts argue that while the strong form efficiency sounds exceptional in the theoretical scene, it is difficult to actually test for it in practice. This is largely due to the due to the fact that legal insider trading consists of the purchasing and distribution of an organization’s stock by a firms trader or director. This form of riding is only considered legal if the trade is not motivated by particular information about the company’s future projections.
Insider dealing is required to be registered with the Securities and Exchange Commissions and this is a fact known to traders. This makes insider dealing generally illegal as it is not legally allowed to trade inside information. This is the main reason analysts do not regard the strong efficiency form and postulate that it may not exist because of the clandestine act of ‘insider dealing. Studies show that a trading strategy that operates under biblically released insider information is more likely to generate abnormal profits, this is a evidence that contradicts even the semi-strong efficiency form.
V. Implications for investors The implications of the efficient market hypothesis for investors of a stock market are: 1 . Remitting for investment research achieves no purpose 2. Examining available accounts and stock market tips will not generate abnormal returns 3. Since information is exhibited in prices instantaneously, investors ought to only expect to culler a normal rate AT return. Knowing International Detour It Is released serves investors no purpose as the price is adjusted before investors have mime to trade 4. Firms should anticipate to receive the fair value for securities they trade 5.
There is no negotiating found on the efficient stock exchange The evidence suggests that strong efficient form does not have strong support, this is due mainly to the fact that the strong efficient form is the most rewarding and persuasive form of efficient market hypothesis from a theoretical perspective but it suffers from one disadvantage in practice; it is complicated to correspond empirically because the essential research would be unlikely to win the cooperation of the appropriate section of the financial population as insider trading is illegal.
The semi -strong efficiency form has a reasonable following, the evidence however suggests that while the events studies is in support of the semi-strong efficiency form, it is not undisputed. This therefore leads me to think that while all 3 forms of market efficiency have drawback, the weak efficiency form is a practical classification of historical returns. This means that the stock prices appear to reflect biblically available information but not all information. VI’. Bibliography Begs, J. (2013) The Efficient Markets Hypothesis. About. Com: Economics [Online].