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INTERNATIONAL APPLIED FINANCE

Capital Market Efficiency


(ACCT 11012)

Group Members:

Waqas Rehman (B00262224) SA RI (B00228142)

Introduction
This report is focus on the capital market efficiency and will make a general overview of the capital market efficiency. For this report, it divided into the definitions of capital market; explaining what efficiency is; information and understanding of the importance of random walk and analysis why take it to the stock market; definition of stock market and discuss is the stock efficiency or not, and the last part is about the efficient market hypothesis.

Capital Market Efficiency


What is capital market? Capital markets typically involve issuing instruments such as stocks and bonds for the medium-term and long-term. In this respect, capital markets are distinct from money markets, which refer to markets for financial instruments with maturities not exceeding one year. Capital market has numerous participants including individual investors, institutional investors such as pension funds and mutual funds, municipalities and governments, companies, organizations, banks and financial institutions. (investopedia, 2013) What is efficiency? In business, efficiency is defined on different levels as the sum total of actions that are aimed at maximising profits while minimising losses and expenditure. This usually involves the reduction of expenditure and costs while increasing performance. In an efficient capital market, security prices rationally reflect available information. (Q&A, 2014) Market efficiency does not mean that share prices are equal to true value at every point in time. It means that the errors that are made in pricing shares are unbiased, price deviations from true value are random. (Arnold.G, 2008: 563 ) In order to explain more clarity on what efficiency is and to deal with peoples a few misunderstanding of it, and efficiency means that prices do not depart from true economic value, you will not come across an investors beating the market in any single time period and no investor following a particular investment strategy will beat the market in the long term. (Arnold.G, 2008:565)

Random walk
What is random walk? Random walk refers to the stock price changes are random and unpredictable. Usually this randomness is thought to imply that the stock market is a non rational, but on the contrary, the random change of stock price shows the market is normal operation or is effective. (baike, 2012) As a drunk peoples irregular walking, maybe after walking several steps he would return to the starting point, but this probability is very small.

(baike, 2012) The chart above, its vertical axis is the location, 0 point is the bar, and the horizontal axis is the steps, the drunken people start from 0 point and he can go to anywhere, this different color curves representing his route, and this chart shows random walk of the drunken people. Take the random walk to the stock market, it means stock price movements are random and unpredictable. The reasons may be are investors whim, natural disasters, company closures and other unpredictable news events and so on. Stock abides by a random walk if the movement of stock prices from day to day does not reflect any pattern.

Why does the random walk occur? A random walk occurs because the share price at any one time reflects all available information and it will only change if new information arises. Successive price changes will be independent and prices follow a random walk because the next piece of news will be

independent of the last piece of news. Shareholders are never sure whether the next item of relevant information is going to be good or bad. (Arnold.G, 2008:568)

(Arnold.G, 2008:569)

Through the chart above we can see in stock market how an efficient market will not allowed unusual profits. Before time A, the share price has shown a cyclical pattern, however, this chart reflecting a desired that over the next six months the share price will raise alone the dotted line. Once this expects by market participants know, people will naturally choose to buy. And this behaviour will lead to the share price to rise and violate the fairness of stock. The stock fairness demand public information resources, it makes an investor have no more useful information to overcome other investors. In the case of complete information disclosure, the share price curve should tend to random walk.

Stock Market Efficiency


A stock market is a place where investors trade certificates that indicate partial ownership in businesses for a set price. Through these transactions, companies can raise the initial capital necessary for various aspects of operation, and those who buy the certificates become entitled to a portion of the business assets and earnings. (Wisegeek, 2010) And the stock market can be divided into the primary market and secondary market. The primary market is a place for realized capital conversion functions, and the secondary market is the transfer of

shares issued market. Efficiency means that the price of securities to fully, timely and accurately reflect the market-related information, investors cannot use available information to adjust the investment strategy to get the long-term excess returns. However, is the stock market efficiency? It is based on efficient market hypothesis, this hypothesis holds that history does not provide any help to predict stock prices, this means that research a stock chart, and even read the relevant Financial Times, they are unable to judge prices trend on tomorrow or next year. It takes rational expectation as the assumption. As long as all related with the stock information rapidly and completely reflected in asset prices, then the stock market is efficiency.

Three Levels of Efficiency


As we know that the best statements or definitions about Capital Market Efficiency are to be found in Roberts (1967) and Fama (1970). According to Eugene Fama
An efficient market is defined as a market where there are large numbers of ration al, profit maximisers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. (Fama, 1970)

This definition indicates that market participants use all relevant information on the basis of accurate values of securities to produce security prices. Connecting this definition there are two basis concerns. Firstly, Is new information fully absorbed and instantaneously effect in a share price? Secondly, either this information is relevant or irrelevant? She distinguished between three types of efficiency; weak, semi-strong, and strong-form efficiency for testing market efficiency. Weak Form Efficiency is a market in which the current price of the market reflects all information fully and instantly considering the past history of security prices. Semi-strong Form Efficiency is said to be that market in which publically available information instantly and fully reflect the current prices of securities. Strong form Efficiency is explained as that market in which both public and private information instantly and fully reflect the current prices of securities.

The Efficient Market Hypothesis and a Random Walk


The efficient market hypothesis is that theory in which it is impossible for the investor to beat the market because shares are always traded at their fair value on stock exchange. share prices completely and instantly reflect all relevant information. In that case it is difficult for the investor to take a decision to either buy an undervalued shares or sell inflated once.

The Theory of Efficient Markets


A. Expected Return or Fair Game Models As we discussed before that mostly definition states that in efficient markets, prices fully reflects all relevant information in general and empirically it has no testable implication. in testable model, price formation must be more specified in detail. also explain more exactly what is meant by 'fully reflect'. B. The Submartingale Model in this model, the price sequence follows the information sequence which is not more than the expected value of next period's price. projecting that th e information is greater or equal than the current price. C. The Random Walk Model In previous efficient markets model, the current price of a share fully reflects all available information and assuming that successive price changes are not dependent . Additionally, it is assumed that he successive returns are distributed identically and these two hypothesis constitute the random walk model. D. Market Conditions Consistent with Efficiency In this model first of all we should determine sufficient capital market efficiency like a market in which 1) no transaction cost from securities, 2) market participants have access of all available information causelessly. Participants must be agreed on the distribution of future prices of each security and implicating the current information for the current pric. Obviously in these types of markets, current prices fully reflect all available information.

Evidence
As empirical researchers has concerned with whether prices fully reflects to subsets of all information. Mostly results comes from Random Walk literature. Attention was focused to se-strong form test considering the speed of price adjustment and publically available information because the extensive test support the efficiency hypothesis. A. Weak Form Tests of the Efficient Markets Model In Random Walks an in Firm Games, the empirical on efficient markets will be considered in the context of general expected returns and evidence directly bears on sub martingale expected return model. in previous literature, the efficient markets model was praised more to random walk model. Mostly authors were concerned with firm game model and empirical evidence in random walk literature is interoperated as 'firm-game' models. In terms of Market Efficiency in the Random Walk Literature we discussed earlier that the implications of 'fair-game' models has impossibility on different trading system. some Random Walks literatures are reflecting the testing of profitability and other literature has concerns with serial covariance of returns. Other Tests of Independence in the Random Walk Literature is probably the best random Walk model as compare to general expected returns model is designing a detailed specification oriented economic environment. Far-Game expected returns mode is the model of equilibrium in which Random Walks helps in environmental conditions in term of distribution of one period returns with time. At this level Random Walk are expected to violate the pure independence but on the other side that benchmark provided by random walk model has effect of insights in the nature of market environment. While discussing the Distributional evidence researchers assumes that the price changes within the transaction is independent. Central limit Theorem takes us to expect that price changes will have normal on Gaussian distribution if the transaction is fairly spread on time. B. Tests of Martingale Models of the Semi-strong Form Generally Semi-strong form test of efficient markets model are more concerned with current prices obviously as a public available information. Every single test is concerned within the adjustment of share prices to single kind of information. Thus each test bring the idea that accumulating these evidence , the validity of the model will be established. Firstly in splits and the adjustments of stock prices to new information the result of a stock split is the multiplication of stock per shareholder without effecting the claims to real state and splits are not source of information. According to the researchers splits are associated with more fundamentally important information. the purpose is to ensure security returns on splits dates to see if they are unusual and calculating the relationship between splits and other variables.

C. Strong Form Tests of the Efficient Markets Models Strong form of the efficient markets model shows interest mostly in those circumstances in which all relevant information is fully effected in the prices with no effected trading profits because they have monopolistic access of information. we cannot take this model as an ideal in terms of reality reasoning that in previous discussion already indicate contradictory evidence. NYSE uses this approach to generate monopoly profits and even managers have monopolistic information about their companies. According to theoretical frame the basic aim is to determine whether managers have adequate access to generate abnormal expected returns and other secondly some funds are better to uncover that information than others. Since these funds produce higher , the special information should be kept insight from public available information. thus this test is not strictly strong form of test for efficient markets model.

Conclusion
Now concluding the whole discussion we had generally the theory is the reflection of efficient markets and its is concerned on prices at any point in time fully reflect all relevant information. As we know that our empirical literature is explicitly based on condition of markets equilibrium in terms of expected returns. As our work id divided into three categories, Strong for test focused on individuals inventions or if it is a group than they have monopoly in accessing the information for price formation. On the other side as we know that Semi-Strong uses all obviously publically available information. And at the end last but not the least in Weak form tests the information which is historical on return sequences. Key Points: The literature on market efficiency suggest that weak market efficiency holds The evidence in support of Semi-strong market efficiency is quite strong (semistrong), but not as solid as weak form efficiency The evidence shows that share prices react to new information speedily as predicted by theory Finally the evidence for strong-form efficiency is relatively weak.

References
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Q&A. (2014). What Is the Meaning of Efficiency in Business?. Available: http://www.ask.com/question/what-is-the-meaning-of-efficiency-in-business. Last accessed 8th Mar 2014.

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