Capital Markets and Market Efficiency Free Essays

Part 1 The Efficient market hypothesis states that all financial markets are efficient in their use of information to determine prices. This means that investors cannot expect to achieve excess profits that are more than the average market profits with similar risk factors, given all available information at the current time of investment, aside from through some form of luck. In part 1 of this report we will discuss the three different forms of market efficiency that Eugene Fama identified in her 1970 report. We will write a custom essay sample on Capital Markets and Market Efficiency or any similar topic only for you Order Now These can be explained as follows: 1) Weak form efficiency Fama (1970) observes that a market is efficient in weak form if past returns cannot be used to predict current stock price changes. It also assumes that prices on assets that are traded publicly already have and use all available information on the stock at any moment in time. It therefore stands to reason that the weak form of the market efficiency hypothesis means that past returns on stock are uncorrelated with future returns on the same stock. Future prices cannot be predicted by studying carefully the past prices of the stock. Excess returns cannot be earned over an extended period of time by using investment strategies that are based only upon the historical prices of shares or differing forms of historical analysis. This means that this style of technical analysis will not be able to produce high levels of returns on a consistent basis for investors. Overall one cannot expect future price changes to be predicted by using the past stock prices. Simply put weak form efficiency a ssumes that historical analysis on past stock data is of no use in predicting future price changes on stocks. 2) Semi-strong efficiency The semi-strong market efficiency form progresses from the aforementioned weak form market efficiency by stating that markets can adjust easily and very quickly to new information that is provided about various stocks. Fama (1970: 383) cites semi- strong efficiency as â€Å"whether prices efficiently adjust to other information that is publicly available. e.g. announcements of stock splits, etc†¦Ã¢â‚¬  Here it is assumed that asset prices fully reflect all of the publicly available information on the stocks meaning that only those investors who manage to possess additional unique information about the stocks could have an advantage over the market to make large gains. This form also asserts that any price outliers are found quickly and on this basis the stock market manages to adjust. In a semi-strong form efficiency share prices are able to react quickly to new information made available publicly in a quick manner so that no large returns can be gained from using the recent information. This leads us to imply that neither fundamental analysis or technical analysis will be able to produce consistent excess returns. Strong-form efficiency Strong-form efficiency assumes that prices reflect completely any type of new information about the market be that public or private information. Fama (1970: 383) says that strong form tests are concerned with â€Å"whether given investors or groups have monopolistic access to any information relevant for formation†, however Fama claims that the efficient hypothesis model still stands up well. The strong form claims the market price also includes different forms of insider information and not solely public information, and this is how it differs from the semi-strong form. The implications of this is that no one at all can therefore have any kind of advantage over the market in prediction of the stock prices as no possible additional data exists which would provide additional value to any investor. However, if any legal barriers exist which prevents the spread of useful information, such as insider trading laws for example, then this form of market efficiency is not possible. Part 2 The Efficient Markets Hypothesis was introduced by Eugene Fama in 1970. The main idea of the Efficient Market Hypothesis is predominantly that market prices must take into account all available information at any given point. Therefore meaning that no one can outperform the market by using readily available public information aside from through luck. A market is said to be efficient if the price fully reflects information about that market, for example if the price of the stock would be unaffected if all information surrounding it was revealed to all stakeholders in that market. Part two of this report will be critically discussing the evidence for and against the Efficient Market Hypothesis and whether it is possible to exploit market inefficiencies. The implications for investors and companies of the Efficient Markey Hypothesis will also be considered. Arguments For the Efficient Market Hypothesis To begin with following the birth of the efficient market hypothesis the theory was widely accepted, and it was widely assumed that the markets were very efficient in taking this information into account (Malkiel, 2003). It was accepted that when information came to the fore this would spread rapidly and would then be incorporated almost instantaneously into the share prices without hesitation. This meant that technical analysis, study of prior stock prices, nor any analysis of relevent information of a financial sense would lead an investment to achieve more successful returns than holding random stocks which have a comparable risk factor. Dimson and Mussavian (1998) observe that the evidence accumulated during the 1960s and 1970s was consistent with the Efficient Market Hypothesis view. There was a substantial backing for the weak and semi strong Efficient Market Hypothesis forms. Even though more recent times have seen an attack against the Efficient Market Hypothesis, Roll (1994) still observes that it remains incredibly difficult to make a high level of profit on a consistent basis even with the wildest variants of stock market efficiency. These violations of market efficiency are often sporadic events that do not last for a period of time. This can be seen by looking at the fact that on the whole profitable investment successes are referred to on a consistent basis as outliers (Dimson and Mussavian, 1998). Malkiel (2005: 2) says that: the strongest evidence suggesting that markets are generally quite efficient is that professional investors do not beat the market. Indeed, the evidence accumulated over the past 30-plus years makes me more convinced than ever that our stock markets are remarkably efficient at adjusting correctly to new information. This is showing that the markets must be efficient due to the fact that professional investors do not on the whole beat the market, and therefore all available information must be taken into account by the market prices and thus there is no gain to be had by any investors by using past prices, or publicly or privately readily available information. Arguments against the Efficient Market Hypothesis Malkiel (2003: 60) observes that by the beginning of the twenty first century â€Å"the intellectual dominance of the efficient market hypothesis had become far less universal† and academics were starting to question the premise and were not accepting it as they had done previously. Shiller (2003 ; 83) states that, â€Å"[contained in the EMH is] the idea that speculative asset prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information.† However he then moves on to discuss how not all information is sensible and not all actors are rational, this would conflict with the efficient market hypothesis which relies on information having a large impact on the prices of stock. As well as this several recent reports have shown a range of empirical evidence which suggests that stock returns can actually possess components of a predictable nature, therefore also rejecting parts of the efficient market hypothesis which profess that looking at past trends do not allow for excess gains when investing on the stocks against the market. Keim and Stambaugh (1986) state that using forecasts based on a number of factors can find statistically significant predictability in a range of different stock prices. Lo and MacKinlay (1988) reject the random walk hypothesis, which is so often considered with the efficient market hypothesis theory, and show that it is not at all consistent with the stochastic nature of weekly returns. Empirical evidence of return behaviour which has been anomalous in the form of variables such as price to earnings ratio (Fama and French, 1992) has defied any kind of usual rational explanation and has resulted in a great number of researchers cons idering their views and opinions of market efficiency. Evaluation and Implications for Investors In conclusion, it is clear to see that market prices are not always predictable and that the markets have made large errors at certain points in time, for example at the recent dotcom internet bubble. Here it was obviously possible to exploit the market inefficiency to make money for investors. In the short run it may be possible to exploit these sporadic inefficiencies, but in the long term true value will always come to the fore. As long as these markets do exist, due to it being reliant on the judgement of investors, there will occasionally be errors made and some participants In the market are likely to behave in a less than rational manner, as is inherent in human nature. As well as this all information will not necessarily be sensible and investors are not likely to necessarily use it rationally. Thus irregular pricing or predictable patterns on stocks can appear and be exploited from time to time. In terms of the implications for investors in terms of the efficient market hypothesis, it is plain to see that all markets cannot be one hundred percent efficient all of the time or there would not be an incentive for people who are professionals in the field to discover different facets of information that is often quickly reflected by market prices (Grossman and Stiglitz, 1980). However, things such as the 1999 dot com bubble are exceptions rather than the rule to providing investors with extraordinary returns on their investments to exploit market inefficiencies. Therefore one could assume that the markets are efficient more often than not, and Fama (1970) is on the whole correct. This could lead to the conclusion in agreeing with Ellis (1998) and the overall idea that active equity management is indeed a ‘loser’s game’. Malkiel (2005) further advises on Ellis’ claim and professes that indexing is likely to produce higher rates of return than active por tfolio management. This is becoming more and more likely to impact investors as markets become more and more efficient, as Toth and Kertesz (2006) show in their examination of an increase in efficiency of the New York stock exchange. Therefore investors are required to question if it is indeed possible or feasible to exploit market inefficiencies using strategies the efficient market hypothesis calls into question. Bibliography Dimson, E. and Mussavian, M. (1998). ‘A Brief History of Market Efficiency’. European Financial Management. 4(1): 91-103. Ellis, C. (1998). Winning the Loser’s Game, McGraw-Hill: New York. Fama. E.G, (1970). ‘Efficient Capital Markets: A Review of Theory and Empirical Work’. The Journal of Finance. 25(2): 383-417 Fama, E. and French, K. (1988) ‘Dividend yields and expected stock returns’. Journal of Financial Economics.(22): 3-25. Fama, E. and French, K. (1992). ‘Common risk factors in the returns on stocks and bonds’. Journal of Financial Economics. (33): 3-56. Grossman, S. and J, Stiglitz. (1980). ‘On the Impossibility of Informationally Efficient Markets.’ American Economic Review. 70(3). 393-408. Keim and Stambaugh (1986). ‘Predicting returns In the Stock and Bond Markets’. Journal of Financial Economics. 357-290. Lo and MacKinlay. (1988) ‘Stock Market prices do not follow random walks : Evidence from a simple specification test’. Review of Financial Studies. (1): 41-66. Malkiel, B. (2003). ‘The Efficient Market Hypothesis and Its Critics Authors’. The Journal of Economic Perspectives, 17(1): 59-82 Malkiel, B. (2005). ‘Reflections on the Efficient Market Hypothesis: 30 Years Later’. The Financial Review (40):1-9 Shiller, R. (2003). ‘From Efficient Markets Theory to Behavioral Finance’. Journal of Economic Perspectives. 17(1) : 83-104. Toth, B. and Kertesz, J. (2006). ‘Increasing market efficiency: Evolution of cross-correlations of stock returns’. Physica 360(2): 505–515. How to cite Capital Markets and Market Efficiency, Essay examples