Efficient Market Hypothesis

The idea of an efficient capital market to the literature of financial economies, put simply is that the intense competition in the capital market leads to fair pricing of debt and equity securities.

This is indeed a sweeping statement. No wonder it continues to stimulate insight and controversy even today. Benjamin Friedman refers to efficient market hypothesis as a credo a statement of faith and not a scientific proposition. Warren Buffett perhaps the most successful investor of our times has characterized the market as a slough of fear and greed un-tethered to corporate realities. For most financial economists, however, the efficient market hypothesis is a central idea of modern finance that has profound implications.

An understanding of the efficient market hypothesis will help you to ask the right questions and save you from a lot of confusion that dominates popular thinking in finance. Given the importance of efficient market hypothesis we will devote this entire article to discuss it and explore its consequences for investment decisions.

Surprise Discovery:

In 1953, Maurice Kendall, a distinguished statistician, presented a somewhat unusual paper before the Royal Statistical Society in London. Kendall examined the behavior of stock and commodity prices in search of regular cycles. Instead of discovering any regular price cycle, he found each series to be a wandering one almost as of once a week the Demon of Chance drew a random number and added it to the current price to determine the next week’s price. Put differently, prices appeared to follow a random walk, implying that successive price changes are independent of one another. In 1959, two highly original and interesting papers supporting the random walk hypothesis were published. A series obtained by cumulating random numbers bore resemblance to a time series of stock prices. Osborne an eminent physicist, examined whether stock price behavior was similar to the movement of very small particles suspended in a liquid medium – such movement is referred to as the Brownian motion.

Inspired by the works of Kendall, Roberts and Osborne, a number of researchers employed ingenious methods to test the randomness of stock price behavior. By and large, these tests have vindicated he random walk hypothesis. Indeed, in terms of empirical evidence, very few ideas in economics can rival the random walk hypothesis.

Search of Theory:

When the empirical evidence in favor of the random walk hypothesis seemed overwhelming the more curious the academic researchers asked the question: what is the economic process that produces a random walk? They concluded that the randomness of stock process was the result of an efficient market. Broadly, they key links in the argument are as follows:

1. Information is freely and instantaneously available to all the market participants.
2. Keen competition among market participants more or less ensures that market prices will reflect intrinsic values. This means that they will fully impound all available information.
3. Prices change only in response to new information that by definition is unrelated to previous information (otherwise it will not be new information).
4. Since new information cannot be predicted in advance, price changes too cannot be forecast. Hence, prices behave like a random walk.

What is an efficient Market?

An efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic value. Note that market efficiency des not imply that the market price equals intrinsic value at every point in time. All that it says is that the errors in the market prices are unbiased. This means that the price can deviate from the intrinsic value but the deviations are random and uncorrelated with any observable variables. If the deviations of market price from intrinsic value are random. It is not possible to consistently identify over or under valued securities.

Weak form efficiency: Prices reflect all information found in the record of past prices and volumes.

Semi strong from efficiency: Prices reflect not only all information found in the record of past process and volumes but also all other publicly available information.

Strong form efficiency: Prices reflect all available information, public as well as private.