Efficient Market Hypothesis

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In a market where all these assumptions apply, the price „fully reflect“ all available informations (Fama, 1969, p. 388), but Fama himself is conscious about, that those conditions do not apply on the real market every day, with keeping in mind, that all those terms are just sufficient and not necessary. For example are not all information freely available. In fact firms like Bloomberg or Reuters get highly paid for providing the news, hence not everybody has access to those information and not at the same time. Another reasoning against those conditions are the implications. In practice not every investor implies an annual report for example the same and the prospects for the future also do differ allot. At the end every condition exist in real at a certain level, and it is about the measuring of the effects in real pricing which is the aim of the investigation. It depends on those levels, how the hypothesis is applicable. The hypothesis assumes that capital markets are efficient, though the efficient market hypothesis(EMH) was defined into three basic forms or levels. The first and lowest efficiency level is called „weak form“.

4 Three Forms of Efficiency

4.1 Weak Form

The crucial part for the pricing of assets in the „weak form“ of the EMH is that there is no implication for the price given by any historical information or movements. Therefore the future price movement has to be entirely resolved by information which are not included jet. Also rules traders use to decide how they participate in the market are completely invalid. Traders use the technical analysis in which they try to find suitable point in time to sell or by a stock only by analyzing the historical movement of each asset.

Thereafter the price movement has to follow a random walk. The random walk theory implies, that market prices are distributed the same and behave uncorrelated to each other. Consequential the historical movements or even current movements cannot be used for future pricing.

By examine the degree of efficiency, a market is efficient in its weakest form, if the price movement is, firstly independent and secondly that the historical data does not imply future movements for the individual asset. This last test is also called trader test and often executed with the use of the filter rule, by which a trader would by a stock, when the observed stock has moved a critical percentage in one direction. [1]Lets assume this is 2%. If now the asset price moves up 2% the trader would set a long position on that asset. The same works for falling prices. If that observed asset would got down for the critical value of 2%, the trader would open a short position until that assets moves up again for 2%. Studies have shown by applying the filter rule with critical values from 0,5% to 20% that only the critical percentage of 0,5% could generate above average return, but taking enormous transaction cost into account, there would be no chance of getting any kind of payout.[pic 1]

4.2 Semi-strong Form

The second level of market efficiency does implies that all public available relevant information are included and respected in the pricing. That means in addition to the historical price data also the public announcements are taken into account for the pricing. Price adjustments to new public information happen nearly immediately without any biases. Hence there is no chance of getting advantages by betting on these announcements.

Therefore neither the technical nor the fundamental analyses can generate above market returns for the investor. The fundamental analyses unlike to the technical analyses does not consider information taken from chart studies or past price movements, it only takes economic and managerial information into account.

Testing the semi-strong efficiency is a bit more complex compared to the weak form tests. Now testing could be done by observing the price change in correlation with relevant events like press conferences or similar actions. According to the theory all public information are already included, hence there is nobody getting advantages by betting on those events.

4.3 Strong Form

The last and highest level of market efficiency is called strong form. The strong form includes in addition to the minor levels of the EMH also the nonpublic information. Consequential historical, public and nonpublic - all - information are already and completely respected in the current share price. According to the theory there is nobody and no machine having stock relevant data which is not included and respected in the pricing. Hence the stock movement is not predictable at all.

Going back to the test from 4.2 it would be possible to gain abnormal returns by betting on an event by using insider information. For example knowing what will be announced or what will be presented. Adding now also the nonpublic or so called insider informations, the chance of using this data to gain an advantage compared to other investors is not possible anymore.

Testing possibilities for example are asking senior managers or other insiders of a company how they would behave by using their access to excess information. Comparing their positions to non insider positions and the respective deposit performance could give indications on the existence and degree of the strong efficiency. According to the theory insider trading would be senseless.

5 Preliminary result

Summarizing the theory market efficiency means, any kind of analysis of charts or company balances does not give the trader an advantage or a greater chance of winning at the capital markets, thus gaining abnormal returns over a long period of time is not possible.

Investors or fund managers have shown opposite performances, but it is important to know, that only achieving excess returns, is no indication for an inefficiency of the market. Rather it can be the result of an investor taking higher risk.

(For computing that exact risk Pricing Models like the Capital Asset Pricing Model (CAPM), a single factor model, or the Arbitrage Pricing Theory (APT), a multi factor model, have to be used.)

6 Criticism and Problems with the EMH

Probably the biggest problems of the EMH are the assumptions for the capital markets. As written above not everybody has access to all informations and nonetheless at the same time. Todays capital markets are nearly completely driven autonomously by opening and closing positions on the stock market by computers. Informations are processed