Efficient Market Hypothesis Assignment
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Added on 2020-10-10
Efficient Market Hypothesis Assignment
Added on 2020-10-10
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Discuss the differences between weak form, semi-strong form and strong form capital market efficiency. Critically evaluate the significance of the efficient market hypothesis (EMH) for a financial manager, using examples or cases in real-life. Introduction Efficient market hypothesis is an interpretation that investors cannot beat the market by obtaining abnormal profits from capital market transactions (ğiĠan, 2015). So, if an investor wants to buy stock based on the positive information in the newspaper report about the stock he is targeting to buy, it might not yield exceptional gains for him. Since, it is believed that the market will react to the actual information when it is delivered publicly. However, the ownership of the economy’s capital stock is determined by the Capital Market by providing accurate signals for allocating the resources. The ideal market is the one in which firms can accurately make production-investment decisions and investors can choose among the securities which fully reflect all available information (Malkiel and Fama, 1970). The Efficient Market Hypothesis (EMH) is the idea pioneered by Eugene Fama which implies that when setting security prices, the competitive financial markets exploit all available information about economic fundamentals which makes share prices behave in a random walk (Malkiel, 2003). Using the EMH concepts, this essay will throw some light on the three categories of EMH and its implications for a financial manager supported by real-life cases and examples. Forms of market efficiency Efficient Market Hypothesis states that the market is generally efficient in nature. An efficient market is one which reflects an unbiased estimate of the intrinsic value (actual value of a stock) of stock’s market price. The market efficiencies are of two types: Operational efficiency and Informational efficiency. EMH does not take into account operational efficiency which is measured in terms of bad deliveries and the time taken to execute the order. Informational efficiency is the reason behind rapid and accurate adjustment of security prices based on the new information in the market in the form of new industrial policy, economic reports, company’s announcements et al. Furthermore, an efficient market functions in three different versions- i.Weak efficient market. ii.Semi-strong efficient market. iii.Strong efficient market. Weak efficient market- In this form of market hypothesis, historical prices form the basis of information i.e. future prices cannot be predicted based on past prices as current prices reflect all the information found in traded volumes and past prices (Gupta and Basu, 2007). It is based on the key principle stock prices fluctuate randomly making it impossible for investors to earn
excess returns taking advantage of such price movements. Additionally, it does not consider the use of technical analysis (Appendix1) or financial advisors for trading in the capital market. For Instance, the earnings from the Apple Inc. (APPL) has beaten analysts’ expectation consecutively in the last five years specifically in the third quarter. Mr. Thompson, a buy–and-hold investor (Appendix2) noticing the pattern and anticipating the hike in stock price after its release, purchases the stock 10 days before Apple reported its third quarter’s earnings. Unfortunately, company’s stock faced downturn in its price opposite to the analysts’ expectations which means that the market is weakly efficient since it doesn’t allow Mr. Thompson to earn excess gains by selecting the stock based on its historical earnings. Figure: Level of information and the markets (Lin, 2016) i.Semi-strong efficient market- In this form of market hypothesis, stock prices adjusts quickly to all publicly available information such as dividend, mergers and acquisitions, earnings, right issue, bonus issue and so on (Ali, et al., 2001). Therefore, stock prices fully reflect all publicly available information which has been disseminated accurately and on time. It doesn’t consider either Fundamental analysis (Appendix3) or Technical analysis for predicting future price of the stock rather only material non-public information (MNPI) is useful for trading. For Instance, Suppose Ryanair’s stock is scheduled to report its earnings on 28thFebruary and just one day prior to it, the stock was trading at £20. A news report published an evening before Ryanair’s earnings call claims that it has suffered in the last quarter due to the recent Coronavirus outbreak. When trading opens the next day, Ryanair’s stock falls to £17, reflecting stock price adjusts to available public information. However, it jumps to £21 after the call. The positive results are the impact of company’s cost-cutting strategy (budget airline), which, if available to investors (i.e. MNPI), would have allowed them to hold the stocks and earn handsome profits.
ii.Strong efficient market-In its strongest form, a market is efficient if both the public and private information relevant to the value of a share (Naseer and BinTariq, 2015) is accurately reflected in its stock prices regardless of the fact that if the information is available to investors (both existing and potential) or not. For Instance, Ms. Zoe who works as a chief engineer at General Motors purchased 10000 shares of General Motors at £35 in the wake of a grand success of new advanced model of automobiles, she was working on. She assumed that there will be upsurge in the share price but the share price did not increase in reality. It implies that market is strongly efficient as it has already adjusted General Motor’s price for expected net present value against the value of a new project (inside information). Market Prices Reflect Forms of market efficiency Past Market Data Public Information Private Information Weak form available not available not available Semi-strong form available available not available Strong form availableavailable available Table: Summary of forms of market efficiency Significance of efficient market hypothesis for a financial manager The sound financial health of an organisation and its clients is the key goal of financial managers. They direct investment activities, perform data analysis, produce financial reports and develop strategies meet the long-term financial goals of the stakeholders (win-win situation for all). The EMH guides the financial managers in managing the investments of the clients (investors) in an efficient way. As financial managers are responsible for managing the finance of the investors to derive maximum benefit out of their funds, EMH highlights the need for financial managers to invest in an efficient market because the efficient market helps them to estimate the true value of the investment and gives an unbiased estimation of the market price of securities. The financial managers exposed to the EMH are more likely to take systematic risk and invest in large diversified portfolio which helps them to generate large capital flows (Atanasov, et al., 2018). As EMH provides correct information about the stock prices, so it is easy for financial managers to raise capital for new investment projects which is nearly impossible to achieve in an inefficient market. Correct information about the cost of equity and resource allocation convinces the investors and does not delay financing the physical investment. The timing of release of financial statements, stock splits, bonus issue, new project announcements etc. will not impact the share price since prices follow a random walk. Hence, financial managers can concentrate on increasing shareholders’ wealth. In an inefficient market, financial managers can make bad decisions by appraising projects based on a wrong basis since NPV will not be the reliable measure. Hence, EMH provides the certainty that securities are fairly priced for the risks that they carry. EMH restricts financial managers in order to offer discounts (extra incentives) to the
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