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
By Kristina Levišauskait
