Efficient Market Hypothesis of Stock Market
Fahid Fayaz Darangay
Efficient Market Hypothesis (EMH) essentially says that all known information about stocks, is reflected into the prices of those securities. EMH does not assume investors to be rational. One direct result of EMH is that an active investor cannot consistently beat the market and a passive investor can earn the profit equal to what active does.
The idea proposed by Fama (1969) suggested that the efficient market hypothesis can have three categories: weak form, semi strong form and strong form. In weak form of hypothesis, it is claimed that all historical information is fully reflected in the actual asset prices.
An investor cannot benefit returns in excess of normal market returns by analyzing trading rules based on information historically available. It is also known as “random walk theory” which states that prices of future securities are random and they cannot be influenced by past events.
Another aspect of efficient market hypothesis is Semi Strong form of efficiency, which assumes that the release of new publicly available material information changes current stock prices rapidly. It does not consider either of the analysis, fundamental (historical prices, trading volume, rates of return, earnings, dividend payments, profitability ratios, stock splits) or technical that can provide an investor any kind of advantage.
The strong form of the efficient market hypothesis provides that all information is completely incorporated in current stock prices, and there is no other information that can give an investor an edge on the market. There is no possibility for an investor to earn in excess of market return given all the available market information.
With inefficient market, stocks that outclass the market will create positive sentiments among investors and while stocks that underperform will create panic in the market. Underperforming Stocks are more sensitive to market information relative to other stocks. There is an inverse relationship between the stock prices’ sensitivity to news and its performance in the market.
The results of these tests have several implications for traders, portfolio managers and policymakers. It can help traders by describing the drift of information among different emerging markets, and for portfolio managers it brings out the dynamic inter- connections between different stock markets over time aiding in creation of a suitable hedging strategy during difficult times such as crashes, financial crises and economic crises.
This study can help policymakers who keep a close eye on the functioning of stock market in order to take accurate decisions. Other than this, it has different strategic policy implications. As we know that inefficient stock market provides a room for advantageous transactions, therefore with this information, Government can decide as to when to reduce interest rates, and assisting them in understanding the repercussions of different economic policies such as exchange rates, inflation and money supply.
Figure depicting the interconnection between three forms of market hypothesis:
This article aims to test the efficiency of the most significant stock exchange markets around the world. The Efficient market Hypothesis states that share prices reflect all the available market information. It states that the stocks always trade at their fair values on exchanges.
This paper provides useful insights into how efficient market hypothesis works and gives valuable information regarding stock fair prices. In this, we take data on various stock exchanges: New York Stock Exchange (NYSE), Sensex, Buenos Aires Stock Exchange and Abu Dhabi Securities Exchange etc. and check whether these exchanges follows efficient market hypotheses or not.
The researchers have used runs test to find out market efficiency. Investors, portfolio managers and executives might find the results of the study handy and it can help them in framing the portfolio decisions and other business policies.
Results
A perfectly efficient market is the one that incorporates information as rapidly as possible. In general, it explains the scale to which the stock prices reflect all available information in the market on the basis of which one can decide about buying or selling the stocks. EMH is also considered to be good way to check whether the stock market is acting as a best means of allocating capital or not. The aim of this article was to investigate the weak form of efficiency of the biggest stock market in terms of trade volume across the world as well as of each of the continent. The Weak Form Efficient Market Hypothesis, which is also known as Random Walk Hypothesis, was tested for these stock markets using Runs Test.
Empirical results founded helps us in concluding that National stock exchange of India (NSEI), Sensex, Buenos Aires Stock Exchange and Abu Dhabi Securities Exchange (A.D.X.) did not accept the null hypothesis and hence are not efficient.
One the other hand, NASDAQ, HSI, Shanghai Stock Exchange (SSE), Dow Jones stock exchange (DJI), National Stock Exchange (NSE), New York Stock Exchange (NYSE) and Toronto Stock Exchange (TSX) accepted the null hypothesis and hence, are weakly form of efficient market.
The various grounds on which the stock market efficiency gets compromised includes lack of liquidity and middle east crisis putting oil production at stake. Also, small traders investing for short term may alter the stock price as they constitute an appreciable amount of regular transactions in the market. These traders do not consider the company’s fundamentals behind key stocks and depends more on technical evaluation of stock prices. Other reasons include overreaction to news, involvement of a substantial numbers of foreign investors, increasing Foreign Portfolio Investment and asymmetrical information which reduces market efficiency.
NYSE is found to be efficient in this paper which is compatible to the mainstream researches and opinions which says that due to technological innovation, instant absorption of information and organized market, NYSE is ideal and the most efficient form of market in the modern financial and investment world.
Sensex is found to be do not accepting the null hypothesis because the Indian stock market has huge number of foreign participants and instability and impatience factor among foreign investors selling off large number of shares which is even more than the capital amount wiped out from the riskier Chinese market during global financial crises. Foreign institutional investors sold a net 168.77 billion rupees which is more than previous record of 153.47 billion rupees in October 2008. Other reasons include uncertainty over U.S. Fed rate hike, higher crude prices and China slowdown.
Argentina is found to have inefficient stock market on account of financial liberalisation, globalisation and market integration which has increased the instability of her stock market. Abu Dhabi Securities Exchange also rejected the null hypothesis and finding indicates the substandard quality of the Abu Dhabi equity market in terms of its efficiency. Liquidity lack is also the main reason behind the market being inefficient.
NSEI is found to be not following the weak market efficiency and thus neglecting random walk theory. This shows that the independent factor in price changes of a stock do not work for NSEI and thus showing a strange result.
Inefficiency in market will create doubts and dilemma among investors leading to the variation in returns one expecting to earn form his/her investment. A lot of ups and downs would be there in the market and price changes contrary to the expectations as the new information arrives in the market. Stock prices may not provide its fair value due to market inefficiency and thus creating problems for companies having low fair value of its shares. These companies may face issues while raising capital, and it can interrupt the pattern of investment in the country in long run.
(The author hails from Anantnag and is currently pursuing Masters in Financial Economics from Madras School of Economics, Chennai)
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