EFFICIENT MARKET HYPOTHESIS (EMH)
6.1 Types of Efficiency
Efficient market hypothesiscan be explained in 3 ways:
a) Allocative Efficiency
A market is allocativelyefficientif it directs savings towards the most
efficientproductive enterprise or project. In this situation, themost
efficiententerprises will find it easier to raise funds and economic prosperity
for the whole economyshould result.
Allocative efficiency will be at its optimal level if there is no alternative
allocation of funds channelled from savings that would result in higher
economic prosperity. To be allocatively efficient, the market should have
fewer financial intermediaries such that funds are allocated directly from
savers to users, therefore financial disintermediation should be encouraged.
b) Operational Efficiency
This concept relates to the cost, to the borrower and lender, of doing business
in a particular market.
The greater the transaction cost, the greater the cost of using financial
market and therefore the lower the operational efficiency. Transaction cost is
kept as low as possible where there is open competition between broker and
other market participants. For a market to be operationally efficient,
therefore, we need to have enough market markers who are able to play
continuously.
c)Information Efficiency
This reflects the extent to which the information regarding the future prospect
of a security is reflected in its current price. If all known (public information)
is reflected in the security price, then investing in securities becomes a fair
game. All investors have the same chances mainly because all the information
that can be known is already reflected in share prices. Information efficiency
is important in financial management because it means that the effect of
management decision will quickly and accurately be reflected in security
prices. Efficient market hypothesis relates to information processing
efficiency. It argues that stock markets are efficient such that information is
reflected in share prices accurately and rapidly.
6.2 Forms of Efficiency
Informational efficiency is usually broken down into 3 different levels (forms):
a. Weak form level of efficiency
This level states that share prices fully reflect information in historic share
price movement and patterns (past information/historic information). If this
hypothesis is correct, then, it should be possible to predict future share price
movement from historical patterns. E.g. If the company’s shares have
increased steadily over the past few months to the current price of Shs.30,
then this price will already fully reflect the information about the company’s
growth and therefore the next change in share prices could either be upward,
downward or constant with equal probability. It therefore follows that
technical analysis or Chartism will not enable investors to make arbitrage
profits. In markets that have achieved this level then security prices follow a
trendles random walk.
, Studies to test this level have been based on the principle that:
• The share price changes are random
• That there is no connection between share price movement and new share
price changes. It is possible to prove statistically that there is no correlation
between successive changes in price of shares and therefore trend in share
price changes cannot be detected. This can be done by using serial
correlation (or auto-correlation) test such as Durbin Watson Statistics.
b) Semi-Strong form level of Efficiency
This level states that share prices reflects all available public information.
(past and present information). If the market has achieved this level, then
fundamental analysis will not enable investors to earn consistentlyhigher than
average returns. Fundamental analysis involves the study of company’s
accounts to determine its theoretical value and thereby find any undervalued
share. Fundamental theory states that every share in the market has an
intrinsic value, which is equal to the present value of cash flows expected
from the security.
Tests to prove semi-strong form of efficiency have concentrated on the ability
of the market to anticipate share price changes before new information is
formally announced. These tests are referred to as Event Studies. E.g. if two
companies plans to merge, share prices of the 2 companies will change once
the merger plans are made public. The market would show semi-strong form
of efficiency if it were able to anticipate such changes so that share prices of
the company would change in advance of the merger plans being confirmed.
Other events that can affect share prices are:
a) Stock splits
b) Death of CEO of company
c) Investment in major profitable projects d) Changes in dividend policy, etc
c) Strong form level of Efficiency
This level states that price reflects all the available public and private
information (past, present and future information). If the hypothesis is
correct, then, the mere publication of information that was previously
confidential should not have impact on share prices. This implies that insider
trading is impossible. It follows therefore, that in order to maximize
shareholders’ wealth, managers should concentrate on maximizing the NPV of
each investment.
Tests that have been carried out on this level have concentrated on activities
of fund managers and individual investors. If the markets have reached the
strong form levels, then fund managers cannot consistently perform better
than individual investors in the market.
6.3 IMPLICATIONS OF EMH FOR FINANCIAL DECISION MAKERS
a) The Timing Of Financial Policy
Some financial managers argue that there is a right or wrong time to issue
securities i.e. new shares should only be issued when the market is at the top
rather than the bottom. If the market is efficient, however, price follows a
trendless random walk and its impossible for managers to know whether
today’s price is the highest or the lowest. Timing other policies e.g release of
financial statements, announcement of
stock splits, etc has no effect on share prices.
6.1 Types of Efficiency
Efficient market hypothesiscan be explained in 3 ways:
a) Allocative Efficiency
A market is allocativelyefficientif it directs savings towards the most
efficientproductive enterprise or project. In this situation, themost
efficiententerprises will find it easier to raise funds and economic prosperity
for the whole economyshould result.
Allocative efficiency will be at its optimal level if there is no alternative
allocation of funds channelled from savings that would result in higher
economic prosperity. To be allocatively efficient, the market should have
fewer financial intermediaries such that funds are allocated directly from
savers to users, therefore financial disintermediation should be encouraged.
b) Operational Efficiency
This concept relates to the cost, to the borrower and lender, of doing business
in a particular market.
The greater the transaction cost, the greater the cost of using financial
market and therefore the lower the operational efficiency. Transaction cost is
kept as low as possible where there is open competition between broker and
other market participants. For a market to be operationally efficient,
therefore, we need to have enough market markers who are able to play
continuously.
c)Information Efficiency
This reflects the extent to which the information regarding the future prospect
of a security is reflected in its current price. If all known (public information)
is reflected in the security price, then investing in securities becomes a fair
game. All investors have the same chances mainly because all the information
that can be known is already reflected in share prices. Information efficiency
is important in financial management because it means that the effect of
management decision will quickly and accurately be reflected in security
prices. Efficient market hypothesis relates to information processing
efficiency. It argues that stock markets are efficient such that information is
reflected in share prices accurately and rapidly.
6.2 Forms of Efficiency
Informational efficiency is usually broken down into 3 different levels (forms):
a. Weak form level of efficiency
This level states that share prices fully reflect information in historic share
price movement and patterns (past information/historic information). If this
hypothesis is correct, then, it should be possible to predict future share price
movement from historical patterns. E.g. If the company’s shares have
increased steadily over the past few months to the current price of Shs.30,
then this price will already fully reflect the information about the company’s
growth and therefore the next change in share prices could either be upward,
downward or constant with equal probability. It therefore follows that
technical analysis or Chartism will not enable investors to make arbitrage
profits. In markets that have achieved this level then security prices follow a
trendles random walk.
, Studies to test this level have been based on the principle that:
• The share price changes are random
• That there is no connection between share price movement and new share
price changes. It is possible to prove statistically that there is no correlation
between successive changes in price of shares and therefore trend in share
price changes cannot be detected. This can be done by using serial
correlation (or auto-correlation) test such as Durbin Watson Statistics.
b) Semi-Strong form level of Efficiency
This level states that share prices reflects all available public information.
(past and present information). If the market has achieved this level, then
fundamental analysis will not enable investors to earn consistentlyhigher than
average returns. Fundamental analysis involves the study of company’s
accounts to determine its theoretical value and thereby find any undervalued
share. Fundamental theory states that every share in the market has an
intrinsic value, which is equal to the present value of cash flows expected
from the security.
Tests to prove semi-strong form of efficiency have concentrated on the ability
of the market to anticipate share price changes before new information is
formally announced. These tests are referred to as Event Studies. E.g. if two
companies plans to merge, share prices of the 2 companies will change once
the merger plans are made public. The market would show semi-strong form
of efficiency if it were able to anticipate such changes so that share prices of
the company would change in advance of the merger plans being confirmed.
Other events that can affect share prices are:
a) Stock splits
b) Death of CEO of company
c) Investment in major profitable projects d) Changes in dividend policy, etc
c) Strong form level of Efficiency
This level states that price reflects all the available public and private
information (past, present and future information). If the hypothesis is
correct, then, the mere publication of information that was previously
confidential should not have impact on share prices. This implies that insider
trading is impossible. It follows therefore, that in order to maximize
shareholders’ wealth, managers should concentrate on maximizing the NPV of
each investment.
Tests that have been carried out on this level have concentrated on activities
of fund managers and individual investors. If the markets have reached the
strong form levels, then fund managers cannot consistently perform better
than individual investors in the market.
6.3 IMPLICATIONS OF EMH FOR FINANCIAL DECISION MAKERS
a) The Timing Of Financial Policy
Some financial managers argue that there is a right or wrong time to issue
securities i.e. new shares should only be issued when the market is at the top
rather than the bottom. If the market is efficient, however, price follows a
trendless random walk and its impossible for managers to know whether
today’s price is the highest or the lowest. Timing other policies e.g release of
financial statements, announcement of
stock splits, etc has no effect on share prices.
