Saturday, August 17, 2013

What is Market Efficiency Theory?

The concept of market efficiency was proposed by Eugene Fama in 1965, when his article “Random Walks in Stock Prices” was published in Financial Analyst Journal.

Market efficiency means that the price which investor is paying for financial asset (stock, bond, other security) fully reflects fair or true information about the intrinsic value of this specific asset or fairly describes the value of the company – the issuer of this security. The key term in the concept of the market efficiency is the information available for investors trading in the market. It is stated that the market price of stock reflects:

 1. All known information, including:
Ø   Past information, e.g., last year’s or last quarter’s, month’s earnings;
Ø   Current information as well as events, that have been announced but are still forthcoming, e.g. shareholders’ meeting.

 2. Information that can reasonably be inferred, for example, if many investors believe that ECB will increase interest rate in the nearest future or the government deficit increases, prices will reflect this belief before the actual event occurs.

Capital market is efficient, if the prices of securities which are traded in the market, react to the changes of situation immediately, fully and credibly reflect all the important information about the security’s future income and risk related with generating this income.

What is the important information for the investor? From economic point of view the important information is defined as such information which has direct influence to the investor’s decisions seeking for his defined financial goals. Example, the essential events in the joint stock company, published in the newspaper, etc.
Market efficiency requires that the adjustment to new information occurs very quickly as the information becomes known. Obvious, that Internet has made the markets more efficient in the sense of how widely and quickly information is disseminated.

There are 3 forms of market efficiency under efficient market hypothesis:
• Weak form of efficiency;
• Semi- strong form of efficiency;
• Strong form of the efficiency. 

Under the weak form of efficiency stock prices are assumed to reflect any information that may be contained in the past history of the stock prices. So, if the market is characterized by weak form of efficiency, no one investor or any group of investors should be able to earn over the defined period of time abnormal rates of return by using information about historical prices available for them and by using technical analysis. Prices will respond to news, but if this news is random then price changes will also be random.

Under the semi-strong form of efficiency all publicly available information is presumed to be reflected in stocks’ prices. This information includes information in the stock price series as well as information in the firm’s financial reports, the reports of competing firms, announced information relating to the state of the economy and any other publicly available information, relevant to the valuation of the firm. Note that the market with a semi strong form of efficiency encompasses the weak form of the hypothesis because the historical market data are part of the larger set of all publicly available information. If the market is characterized by semi-strong form of efficiency, no one investor or any group of investors should be able to earn over the defined period of time abnormal rates of return by using information about historical prices and publicly available fundamental information(such as financial statements) and fundamental analysis.

The strong form of efficiency which asserts that stock prices fully reflect all information, including private or inside information, as well as that which is publicly available. This form takes the notion of market efficiency to the ultimate extreme. Under this form of market efficiency securities’ prices quickly adjust to reflect both the inside and public information. If the market is characterized by strong form of efficiency, no one investor or any group of investors should be able to earn over the defined period of time abnormal rates of return by using all information available for them.

The validity of the market efficiency hypothesis whichever form is of great importance to the investors because it determines whether anyone can outperform the market, or whether the successful investing is all about luck. Efficient market hypothesis does not require to behave rationally, only that in response to information there will be a sufficiently large random reaction that an excess profit cannot be made. 
The concept of the market efficiency now is criticized by some market analysts and participants by stating that no one market can be fully efficient as some irrational behavior of investors in the market occurs which is more based on their emotions and other psychological factors than on the information available But, at the same time, it can be shown that the efficient market can exist, if in the real markets following events occur:

Ø   A large number of rational, profit maximizing investors exist who are actively and continuously analyzing valuing and trading securities;

Ø   Information is widely available to market participants at the same time and without or very small cost;

Ø   Information is generated in a random walk manner and can be treated as independent;

Ø   Investors react to the new information quickly and fully, though causing market prices to adjust accordingly.

By Kristina Levišauskait