The Efficient Market Hypothesis Essay

1836 words - 7 pages

1. INTRODUCTION
The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to explain human investors’ behaviors.

2. MAIN BODY
A generation ago, it was generally believed that security markets were efficient in adjusting information about individual stocks and stock market as a whole (Malkiel, (2003)). However, we cannot deny the efficient market hypothesis has several paradoxes.

In the first place, a main theoretical cornerstone for the EMH to be a consequence of equilibrium in capital markets is that markets are always rational. This is against the realism. Even if the foregoing assumption turn out to be entirely possible, many recent studies have concluded that rationality is not always a realistic assumption as investors in many cases engage in irrational investment (Kahneman and Riepe, (1998)).

Second, the efficient market hypothesis cannot explain market anomalies. These market anomalies include the pricing/earnings effect, the size and January effect, the monthly effect, holiday effect and the weekend effect. These anomalies indicate either market inefficiency or inadequacies in the underlying asset-pricing model (Schwert, (2002)). When talking about the test on efficient market hypothesis, we know in weak-form efficiency, Fama (1965) found no evidence of abnormal returns with trading strategies based on technical analysis and concluded that security prices in most cases follow random walks. The weak-form efficiency cannot explain January effect. In semi-strong-form efficient market, to test this hypothesis, researchers look at the adjustment of share prices to public announcements such as earnings and dividend announcements, splits, takeovers and repurchases. As time goes, later tests tend to be not supportive to EMH. For instance, semi-strong-form efficiency cannot explain the pricing/earning effect. In strong-form efficiency, the highest level of market efficiency, Fama (1991) pointed out the immeasurability of market efficiency and suggested that it must be tested jointly with an equilibrium model of expected. However, perfect efficiency is an unrealistic benchmark that is unlikely to hold in practice.

Last but not least important, an efficient capital market is one in which stock prices fully reflect all available information. However, the paradox is that since...

Find Another Essay On The Efficient Market Hypothesis

‘The efficiency of a stock market is essential in order for a stock market to be an efficient allocator of resources.’ Discuss

1396 words - 6 pages existing markets. The following bar chart below, details the relative size of emerging stock markets around the world according to the total number of shares (markets capitalisation). Stock Market has two markets where primary market, companies issues new equity and secondary market where all the trading takes place. An efficient stock market is described in the as ‘one in which information is processed quickly and accurately and so share process

The Tests for Market Efficiency Essay

2337 words - 9 pages During the 20th century, academic financial economists extensively accepted the efficient market hypothesis. Almost everyone was alleged that stock markets and securities market are highly efficient in response to any new information in the market. It was argued that when information regarding factors influencing market arises, the information spread like wild fire in the market and the prices of stocks adjust accordingly without any delay. This

Stock Market: efficient allocator of resources?

1735 words - 7 pages reflect’ all available information. (Farma 1970).It’s important that society’s scarce resources are allocated efficiency, Stock markets help in this process. In an efficient stock market security prices reflect all available information. The efficient market hypothesis (EMH) implies that if new information is revealed about the firm it will be incorporated in to the share price rapidly and rationally, with respect to the direction of the

Yay For Papers

734 words - 3 pages of the 90’s) and the worst lows (Great Depression of the 30’s). The States are currently in a downward spiral that it seemingly cannot escape from. From this basic problem has sprung two main schools of economic market theory over the past decades. One is the Efficient Market hypothesis created by George Fama who “sees markets as rational” and the other is Shiller’s ‘behavioral economics’ which supports his notion of “a market riddled with

Can above-average returns be earned on observing stock market overreaction?

9651 words - 39 pages securities are followed by a reversal this could be interpreted as being at variance with the efficient market hypothesis. If this is the case, a specific trading rule could be applied in order to make short-term profit based on observing the previous days trading.Overall there has been extensive research on the subject of stock market overreaction. Several hypotheses have been developed to explain how stock prices respond to information. The

How Changes in Oil Prices Affect Stock Market

1109 words - 5 pages political event in the Middle East can have a large impact on ‘precautionary demand’, which mean stock market returns decline. Methodology: a) Market Efficiency in Event Studies:- Market Efficiency, or the ‘Efficient Market Hypothesis’ (EMH) is the notion developed by Eugene Fama (1970) that stock prices incorporate all available information as soon as they are available (Wong, 2002). There are three forms of the EMH. Firstly, the weak form

What Is An Efficient Market?

898 words - 4 pages the information efficiency of the market is the Efficient Markets Hypothesis (EMH). The information efficiently is classified according to how fast and accurate security prices react to new information, in such a way that nobody be able to get abnormal return. All information can be divided into three types: past information, public available information and all information. In accordance with the Fama’s classification there are three types of

Behavioral Finance: Heuristics and Biases

850 words - 4 pages to describe the perspective of the individual as the reference point to establish the value of an outcome. Kahneman and Tversky’s work as psychologists, not financial academics, has provided the fundamentals for behavioral finance. These two attempted to illustrate why the Efficient Market Hypothesis is an incomplete and potential defunct theory; it was lacking human sentiment. Human beings tend to hold either a gambler’s fallacy or a hot hand

Indexing in Investment Strategies and Behavioral Finance

2185 words - 9 pages viewpoint with respect to the Efficient Market Hypothesis (EMH) and analyzes the effects of mispricing on average returns achieved by investor. Passive Management Strategy The supporters of the efficient market hypothesis believe that active management is a largely wasted effort and does not support the expenses incurred due to the mispricing of stocks (Barberis and Thaler, 2003).Therefore, they advocate passive investment strategy that makes no

Predicting Stock Market Return

2028 words - 8 pages efficient stock market it has not been possible to predict stocks, due to the failure of stock market variables not being statistically considerable. Furthermore, some authors have agreed to equate the comparison of stock market efficiency with the non-predictability property. However, this debate has no satisfactory results and this has also not specified the achievement of understanding market functions. Obligations of the hypothesis of market

Stock Asset Returns Are Predictable Part 1

2232 words - 9 pages . Mathematical models of asset pricing have an unusually rich history as compared to every other aspect of economic analysis. For tests of return predictability, information set is defined as the past history of stock prices, company characteristics, market characteristics and the time of the year. The Efficient Market Hypothesis was first introduced by Louis Bachelier, a French mathematician in 1900 in his dissertation. Efficient Market Hypothesis

Similar Essays

The Efficient Market Hypothesis Essay

849 words - 4 pages The efficient market hypothesis has been one of the main topics of academic finance research. The efficient market hypotheses also know as the joint hypothesis problem, asserts that financial markets lack solid hard information in making decisions. Efficient market hypothesis claims it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information

Efficient Market Hypothesis Essay

947 words - 4 pages Efficient Market Hypothesis (EMH) that was thought up by Eugene Farma in his Ph.D. dissertation in the 1960s. As part of the EMH there are three possible levels of efficiency. These include weak, semi-strong, and strong form. In the weak form of market efficiency it is assumed that all past prices and past public information of a security are reflected in the securities current price. In the semi-strong form of market efficiency it is assumed that

Efficient Market Hypothesis Essay

2741 words - 11 pages The quote shows a strong relation to the efficient market hypothesis (EMH), as it implies that the costs of capital are dependent from the amount of information given by the company. According to my opinion, agency theory is a good explanation for costs of capital. Agency theory defines contracts as under which one party – called principal – engages another party – called the agent – to perform service

Efficient Market Hypothesis And Behavioural Finance

2529 words - 10 pages Efficient Market HypothesisThe efficient market hypothesis (EMH) is a belief that financial asset markets are fully efficient and thus correctly reflect all information. It evolved in the wake of work by Kendall (1953). He found price seemed to follow random walks, so that future price changes could not be predicted on the basis of past prices. The importance of news for asset prices led to the idea of the EMH.DefinitionThe efficient markets