Efficient Market Hypothesis

EBS Business School

EBS Universität für Wirtschaft und Recht

Literature Review

„The market efficiency hypothesis“

Spring Term 2015

Student Number:         24032188

Supervisor:                 Prof. Karapandza

Word Count:                2828

Submission Date:        1. June 2015

Table of content

1        Introduction        ………………………………………………3

2         Definition        ………………………………………………4

3        Approach        ………………………………………………4

4         Three forms of Efficiency        ………………………………5

        4.1         Weak-form         ………………………………………5

        4.2         Semi-strong form        ………………………………6

        4.3         Strong Form        ………………………………………7

5         Preliminary Result        ………………………………………8

6         Criticism and Problems with the EMH        ………………8

7         Testing        ………………………………………………9

8         Conclusion        ………………………………………………11

Reference List        ………………………………………………12

1 Introduction

        „The primary role of capital markets is allocation of ownership of the economies capital stock“ (Eugene F. Fama, 1969).

        Over the past decades, the capital market has grown enormously. Capital markets around the world determine economies and politics. The time has shown, whether  the pursuit of wealth or the acknowledgement urge people to the capital markets. Everyone thinking about winning against the market. The most people loose after a few day, months or years.  Some others win and from than live in prosperity.

        This leaves the question mark of whether it is possible or not to win against the global capital markt.

        Eugene F. Fama, a financial economist born 1939 in Boston, MA USA, discussed in his thesis: Efficient Capital Markets: A Review of  theory and empirical Work, whether the capital markets are efficient. If so, it would be impossible to win against them (nobelprize.org, 15 Feb. 2015).

        Opinions about this theory range from believing in full efficiency to thinking there is no efficiency. Like every story, a theory has its flipside. To discuss whether this hypothesis is true or not, the general consensus leads to the statement, on earth there are multiple efficient markets coexisting with some anomalies (Karapandza, 2012).

        According to Eugene F. Fama the prices of securities fully reflect available information. Thereafter it is impossible to „beat the market“, because all necessary information are already respected in the market price (investopedia.com, 15 Feb. 2015)

        Several Banks and Fondsmanagers have shown, it is possible to gain above average winnings over a long period of time. Also there are even algorithms fighting with success against the market. Wether these examples refute this statement or not, it is a hypotheses which worth the investigation.

2 Definition

        At the very beginning the clarification of the definitions is as important as the justification.

        According to Fama 1970, the ideal conception is a market where each present stock price perfectly respects the true value of the company and all considerable information are already respected in the price (Fama, 1969, p. 383).

        Therefore the underlying factor for the pricing are the relevant information for each asset. Fama decided to define the theory into three „information subsets“(Fama, 1970, p. 383). These subsets represents three different degrees of market efficiency.

        The first degree is called the weak form of the Efficient Market Hypothesis (EMH), in which only the historical data of the stock quotation give reasoning for the fair pricing.

        The second degree ist the semi-strong form, where all relevant public information are additionally to the historical data available for every party in the same manner.

        The third and most discussed degree of Fama’s hypothesis ist called the strong efficiency. In this scenario both, the first and second degree form, are combined, but additionally all nonpublic information are already included in the stock price. In this case all conceivable pertinent information are already respected and fully represented in the current stock price. Hence there ist no predictability for the future movement of the price.

3 Approach

        Before starting with the analysis and testing the hypothesis, it is important to also clarify the overall market conditions. Fama calls them sufficient but not necessary conditions (Fama, 1969, 387).

        According to Fama there are three major conditions for the market efficiency. First, there are no transaction cost, which might falsify the cost of buying a stock. Second, everybody got access to all relevant information in the same manner, which means that every market participant receives the information at the exact same time in the exact same form and the last condition says, that all the information are implied the same way.