22.(И.К.)Efficient Market Hypothesis (emh): Concept, Forms, Arguments for and against.

efficient-market hypothesis (EMH)

Definition. An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. In an efficient market, investors can expect only to receive a „fair‟ risk adjusted return on their investment.

The EMH deals with “prices efficiency”. Pricing efficiency is important because:

• Investors need to be sure they will be able to sell their investment for a fair price, and are unlikely to pay over the fair price for what they buy. In the absence of reassurance on this investors will shun the financial markets and the flow of funds to investment will slow.

• Directors and managers can rely on the market to give correct feedback on the consequences of their past actions and alternative future plans. Also share returns on the market are used to estimate the cost of equity capital for firms; inefficient pricing will lead to inappropriate required returns on equity. However, shares will only be priced correctly if directors communicate in an appropriate manner with the market.

If capital markets are efficient, then the purchase or sale of any security at the prevailing market price must be a zero net present value (NPV) transaction. In other words, the price paid for the security exactly equals the present value of the expected future cash flows from the security, discounted at the investor’ risk-weighted required return.

An efficient market reflects available information – but what sort of information? Three levels of market efficiency are often identified:

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong".

Weak form efficiency. Weak EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information The market price includes all historic price information but no forward-looking information. In this case past share price information cannot be used to make excess returns because all this information is already incorporated in the current price. If the market is weak form efficient, then technical analysis (chartism) is of no use, as it is based on past price history. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium. However in a weak-form efficient market fundamental analysis of financial statements can be used to identify stocks that are undervalued and overvalued.

Semi-strong efficiency. Prices reflect and react immediately and appropriately to all available public information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. Investors can make profits by using non-public (“inside”) information. Semi-strong form efficiency encompasses weak form efficiency. Semi-strong EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. Strong EMH additionally claims that prices instantly reflect even hidden or "insider" information.

Strong efficiency. All possible information is immediately incorporated in the share price, so not even insider information can be used to make excess returns. Strong form efficiency encompasses semi-strong form efficiency. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time.

The EMH is more likely to hold when:

• information is readily available to all investors at low cost;

• transaction costs are reasonable;

• there is no significant player who has access to superior information enabling them to outperform (e.g. a central bank in its local government bond market clearly has an edge in terms of information).

Arguments against:

• The EMH implies perfect forecasting ability. The reality is quite the reverse. If the EMH is true, we expect prices to move randomly with the arrival of (unpredictable) new information.

• Random prices imply irrationality.

• Portfolio managers who do not beat the market are incompetent. If the market is semi-strong form efficient, only investors with insider information can beat the market. The rest are subject to luck – half will outperform, half will underperform.

• It does not matter what stocks an investor holds. This is untrue, because a portfolio should be well diversified and reflect an investor’s risk/return preferences .

• Shares do not depart from true economic value. If true economic value is defined as the NPV of future fixed cashflows, then this is not true because those future fixed cashflows are not known with certainty.