Concepts of Market Efficiency and Empirical Approaches to Testing Essay

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Market Efficiency and Empirical Approaches to Test for it

A review and discussion of market efficiency

A financial market is efficient with respect to information item, if the new information has fully influenced the market prices. In an efficient market, when a new information is made available its impact is said to be instantaneous or rapid and unbiased to the financial assets' current market prices.

There are three different hypotheses that have been formulated to try and explain market prices, in respect to what kind of information is availed to the market. The weak version of efficient market hypothesis suggests that the changes in market prices are in respect to all the information that the public has had in the past. The semi-strong form of hypothesis suggests that the current prices in the financial market is a reflection of all the information that the public, and that the introduction of new information is also bound to change these prices. The strong form hypothesis of efficiency market on the other hand suggests that prices in the financial market are a full reflection of the information that is already known to the market participants.

This is essay is a review and discussion of market efficiency and empirical approaches to test for it. It initially begins with an empirical review of efficiency market followed by a review and discussion of the efficiency market hypothesis. The third section of this essay looks at the efficiency markets from a risk and return perspective, the third section re-examines some empirical tests for semi-strong efficiency. Before concluding this study spells out a critical analysis of risk and return perspective.

The concept of efficiency markets -empirical review

Based on observation and experiment it is without doubt that the subject of finance is also built on the concept of efficiency. According to Fama, (1970) and other financial analyst they have referred to efficiency market as a market in which the financial assets prices are determined or affected by any relevant information that relates to these financial assets. In his studies Samuelson (1965) noted that the prices of financial assets is a reflection of the present, past and even future events, however this events show no precise relation to changes on prices of financial assets, he further goes on to say that thou the market doesn't predict the price changes, it can mathematically evaluate the likelihood of these price changes occurring.

The concept of efficiency market has various hypotheses which can be viewed as being consistent with the random walk model which tends to proof that the financial assets price changes have no predictable bias pattern, and also the same model can be applied for better understanding of price formation in the competitive markets. Finance has applied this model on consecutive returns that are independent to prove that in a series of financial asset prices that occur at close interval it is difficult to identify any systematic effect that might be affecting the price movements, as the data observed shows a pattern that is equal to a wandering series.

Contrary to the earlier definition given on the concept of efficiency market; Burton (1987) contradicts by writing that, on theory a market that is efficient is one which by using the information available otherwise known as information efficiency is likely to fail in generating abnormal profits on the financial assets of the market. In his studies he ads on that a market can only be deemed to be efficient if it posit a model for returns and that the test for market efficiency is also a test for asset pricing model and market behavior (Burton, 1987).

The efficient market hypothesis

There are three forms of hypothesis that exist in the efficiency market that are namely the; weak, semi-strong and strong versions of hypothesis. Same as the concept of efficiency market these hypothesis were initially expressed on a thesis termed as "the theory of speculation," which was written in 1900 by mathematician Louis Bachelier who was a Frenchman pursing a PhD in mathematics at that time. These hypotheses had being widely ignored since Bachelier formulated them and various economists cited that the main problem with them was that it claimed financial assets, which have low prices to earnings do generate higher returns than other financial assets. These later changed in the 1960's after the hypotheses were reviewed and refined by other prominent economists who provided substantial evidence to support them. Among such prominent economist were Paul Samuelson who wrote the evidence for a version of the EMH, Eugene Fama who in his studies rooted for the random walk hypothesis and Paul Cootner whose work also refined the theory so as to become applicable.

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Both of these version of hypotheses claims that the financial market is "information ally efficient," this means that based on the fact that information pertaining to investments in the financial market are usually available to the general public when investments are being made no investor can get returns from his or her investments that is highly in excess of the market's average returns on a risk-adjusted basis. This fact is consistent to the earlier argument by Burton (1987) who claimed that on theory a market that is efficient is one which, by using the information available is likely to fail in generating abnormal profits on the financial assets of the market.

Critics of the efficiency market hypothesis link them to a rational market rather than an efficient market and they further blame such ideas as the contributing factors to the financial crisis witnessed in between 2007 and in the early part of 2010. This criticism has also been applauded by various economists who also blame the rational behavior of the investment public for the recently witnessed financial meltdown. However the advocates of the hypothesis have lodged their defense arguing that relating efficient market hypothesis with market stability is unwarranted and that when information available to the public is unstable, the market can as well be unstable.

Each of these hypotheses has different impact on how the financial market operates and it is important to note that the EMH require market participants to have rational expectations i.e. whenever new information is availed to the market participants should change their expectations consistently with the new information. Investors in the financial market have been observed to either overreact or under-react after receiving new information, however the EMH only require these reactions to be random and in line with a normal distribution pattern so as to avoid making abnormal profits.

The weak form of efficiency market

The weak version of efficient market hypothesis is based on the fact that the prices of financial assets such as bonds, stocks or property are an indication of all the information that the public has had in the past.

Based on experiments and observation conducted by Beaver (1968) he concluded that among the three hypotheses of efficiency market; the weak form of efficiency market 'holds more water 'than the rest, this in other terms means that results of the empirical analysis conducted are full in support of this hypothesis unlike the other two hypothesis.

The weak version of EMH has some implications on market operations that that include; future market prices cannot be predicted using prices or information from the past, also it will be impossible to earn abnormal returns in the long run using historical data or market prices as an investment strategy. This hypothesis further claims that technical analysis techniques are unlikely to generate excess returns unlike fundamental analysis which can. Also the market prices show no signs of serial dependencies, thus there is no set pattern for these prices. Prices in the financial market are largely determined by relevant information and not the price pattern; consequently this means that market prices follow the random walk model hypothesis (Fama et al. 1969).

An empirical test for weak form of efficiency market hypothesis tries to look at the relation between the information the public has had in the past and the pattern of financial markets activities. The test tries to prove whether financial markets are information ally efficient and that market prices rapidly adjust to information which the public has had in the past.

The semi-strong form of efficiency market

The semi-strong form of hypothesis argues that prices in the financial market is a reflection of all the information that the public already has and that these prices change immediately when a new information is availed to the public.

The implication of the semi-strong form of EMH to the financial market is that market prices rapidly adjust in an unbiased manner to new and relevant information that the public has. The empirical studies conducted on semi-strong hypothesis try to evaluate the rate of adjustments of market prices to new information that has been made available to the investing public; these studies provide evidence to prove how market prices react rapidly and in unbiased manner to new information such as earning announcements and stock splits.….....

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