Efficient Market Hypothesis

Efficient Market Hypothesis

When establishing financial prices, the market is usually deemed to be well-versed and clever. In a stock market, stocks are based on the information given and should be priced at the accurate level. In the past, this was supposed to be guaranteed by the accessibility of sufficient information from investors. However, as new information is given the prices would shift. “Free markets, so the hypothesis goes, could only be inefficient if investors ignored price sensitive data. Whoever used this data could make large profits and the market would readjust becoming efficient once again” (McMinn, 2007, Ð'¶ 1). This paper will identify the different forms of EMH, sources supporting and refuting the EMH and finally evaluating if the EMH applies to mergers.

Three forms of the Efficient Market Hypothesis

Eugene Fama coined the term, efficient market hypothesis (EMH) in the 1960s. There are three forms of the efficient market hypothesis: the weak, semi-strong and the strong form. The weak form of the EMH states that the past price and volume is indicated by current asset prices. The current market price of security is revealed by the information controlled by previous series of prices. “It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that "everybody else knows" (Han, 2008, Ð'¶ 6).

The semi-strong form of EMH states that all information that is made publicly accessible is included in the asset prices. Public information is not limited to past prices. Financial statements, economic factors and other data is included. This form of EMH suggests that just because everyone may have the same information, this does not give organizations access to surpass the market.

The last form of the EMH is the strong form and it suggests that “private information or insider information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security's current market price” (Han, 2008, Ð'¶ 8). This appears to be an unfair advantage because if a manager of an organization has insider information then they are not able to benefit from the information they possess.

Sources supporting the efficient market hypothesis

Since Fama, coined the efficient market hypothesis researchers have been studying its correlation to the market. “Supporters of the efficient market hypothesis can argue that many seeming violations of the hypothesis are instead examples of the вЂ?bad model’ problem. Under this interpretation, predictable excess returns represent compensation for risk, which is incorrectly measured by the asset-pricing model being used” (Beechey, Gruen, & Vickery, 2000, Ð'¶ 2). The longer the violations remain unexplained though using the efficient market hypothesis models it will most likely apply increasingly less force.

Supporters of the EMH have always responded in many ways. “Supporters of the EMH have responded to these challenges by arguing that, while behavioral biases and corresponding inefficiencies do exist from time to time, there is a limit to their prevalence and impact because of opposing forces dedicated to exploiting such opportunities...market forces will always act to bring prices back to rational levels, implying that the impact of irrational behavior on financial markets is generally negligible and, therefore, irrelevant” (Evolution of the Efficient Market Hypothesis, 2007, Ð'¶ 8). Supporters of the EMH, have been quite successful at refuting the claims of anomalies found against the EMH. Understanding the EMH has been valuable to many individuals and they are the EMH’s greatest supporters.

“Jensen and other supporters of this view believe investors to be rational, informed decision makers, basing their decisions on the fundamentals that determine the profits or earnings of a firm, which in turn determines the price of their stock” (Montego, n.d., Ð'¶ 2). This statement assumes that the stocks can reach their intrinsic value everyday assuming that there are full information and no market failures. Jensen’s statement allows investors to speculate about the market. Being able to speculate about the market is good because it allows more trading and speculation resulting in a more efficient market.

Sources refuting the efficient market hypothesis

Over time as people began to analyze the efficient market hypothesis it appears that several anomalies in the capital market were discovered. One of the anomalies discovered was the January Effect. According to Kolahi (2006), Rozeff and Kinney were the first to observe the January Effect anomaly. In the January Effect it was discovered that the return on common stocks were especially high during January compared to other months. The way that the January Effect works is that investors would sell their small cap stocks at the end of the year to write off their losses during the end of December and the first week of January. This effect went against the EMH because the EMH states that the stock prices cannot be predicted but the January Effect proved otherwise.

There were many arguments made against the efficient market hypothesis by Grossman and Stiglitz. “Grossman and Stigliz argued that perfectly efficient markets could only exist if there was no cost to acquiring information. If there were a cost to information collection, then there would be no economic justification to this activity as current prices would already incorporate all current information” (Shadbolt & Taylor, 2002, p. 24, Ð'¶ 2). In situations such as this it provided no reason to trade since profits were not able to be made while the financial markets could deteriorate.

In 1981, Robert J. Shiller produced proof showing that the stock market is volatile. His findings had astounded the economists and financial practitioners of the world. “To demonstrate that stock prices are excessively volatile Shiller used a long time series of value and annual dividends on the S&P (the market) portfolio over the period 1871вЂ"1979, denoted by P1, P2, . . . ,PT,, and D1, D2, . . . DT, respectively.