Introduction of the Topic Historical Background Random Walk Theory Forms of Markets & Tests EMH vs.

Fundamental & technical Analysis Competitative Market Hypothesis Conclusion

Topics to be covered in the Presentation:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.

In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security New information regarding securities comes to the market in a random fashion. Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information.

There are three major versions of the hypothesis: Weak Semi-Strong Strong

First, market prices are efficient with respect to publicly known information.

Second, market efficiency is a relative concept.

Third, investing is fair game if the market is efficient.

Historically, there was a very close link between EMH and the random-walk model.
The random character of stock market prices was first modeled by Jules Regnault, a French broker, in 1863 and then by Louis Bachelier, a French mathematician, in his 1900 PhD thesis, "The Theory of Speculation". The efficient-market hypothesis was developed by Professor Eugene Fama at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when behavioral finance economists, who had been a fringe element, became mainstream.

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1965 Eugene Fama published his Thesis arguing for the random walk hypothesis, and Samuelson published a proof for a version of the efficient-market hypothesis. In 1970 Fama published a review of both the theory and the evidence for the hypothesis.

the random walk of stocks and other securities is better explained by the same concept used to explain Brownian motion

Robert Browning in 1827 introduced this concept which was further classified in mathematical form by Albert Einstein in 1905.

So how does this apply to the stock market?

In Random-walk theory the decisions of investors highly effects the stock prices to go up or down in a random way.
stocks and other security price changes are the result of the equilibrium of supply and demand. A change occurs in Stock price due to certain changes in the Economy, industry or company.

Information about this changes the stock prices immediately and the stock moves to a new level, either upward or downward depanding upon the information.
Hence Random Walk theory was later on named as EMH.

The Capital market is considered to be efficient in three different forms; the Weak , the Semi-Strong and Strong form. Weak Form:- deals with information regarding past security price movements Semi-Strong:- deals with publicly available information

Strong:- deals with both public and private information.

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The weak form of the market hypothesis (EMH) says that the current prices of stocks already fully reflect all the information that is contained in the historical sequence of price.

Two approaches have been used to test weak form, one approach looks for statistically significant patterns in security price changes. The alternative approach searches for profitable short term trading rules.

Serial correlation test:- it can calculate the correlation between price changes in one period and changes for the same stock in another period, the correlation coefficient can take on value ranging from -1 to 1.

Run test:- it also test the randomness in stock price movements. It ignores all the absolute values, only the direction of change is considered. An increase in price is represented by +ve , decrease by ve and when there is no change then 0.

Filter test:- it is developed as direct tests of specific mechanical trading strategies to examine their validity and usefulness. These trading strategies are formed to earn excess returns, the strategy is called Filter Rule. The alternative to this strategy is Buy and Hold strategy.

The semi-strong form of the efficient market hypothesis says that current prices of stock not only reflect all informational content of historical prices, but also reflect all publicly available information about the company being stuided. Examples of publicly available information are : corporate annual reports, company announcements, press releases etc. The implication of semi-strong hypothesis is that fundamental analysts cannot make superior gains by undertaking fundamental analysis because stock prices adjust to new pieces of information as soon as they are received.

the impact on the share price on an economic event is measured out by taking the difference between actual return and expected return.

The model used for estimating expected returns is :

Ri = ai + bi Rm + ei

This analysis is known as Residual analysis.

It may be stated that a great majority of the semi-strong efficiency tests provide strong empirical support for the hypothesis.

In strong form no information whether it is public or inside, can be used to earn superior returns consistently. The strong form efficiency tests involve two types of tests.
The first type of tests attempt to find whether who have access to inside information have been able to utilize profitably such inside information to earn excess returns. The second type of test examine the performance of mutual funds and the recommendations of investment analyst to see if these have succeeded in achieving superior returns with the use of private information generated by them.

In conclusion, it may be stated that the strong form hypothesis is invalid as regard to inside information, but valid as regards private information other than inside information.

Effiecient market hypothesis

Efficient market hypothesis consists of three forms. Weak form of EMH directly contradicts technical analysis.

Fundamental analysis
Seeks under priced securities and over priced securities by analyzing key economic and financial variables we can estimate the intrinsic worth of the security and then determine what investment to make

Technical analysis
It states that fundamental analysis is unnecessary. Predicts future movements in share prices by studying historical patterns in share price movements.

The semi-strong form of EMH contradicts fundamental analysis. The strong of EMH maintains that not only is publicly available information useless , but all information is useless to investors or analysts. Both fundamental and technical analysis are required to make the market efficient

The research studies on EMH have shown that price changes are random or independent & hence unpredictable. Concluded that prices are set in a very competitive market, but not necessarily in an efficient market. The competitive market hypothesis provides scope for earning superior returns by undertaking security analysis and following portfolio management strategies.

Although the efficient market hypothesis is a useful heuristic concept that may shed some light on trading and the markets, I believe that a more plausible reason to explain the inability of most investors to outperform the market, especially by active trading, is because there are so many factors affecting the prices of most investment products, that no one can know and quantify all of these factors to arrive at what the future price of anything will be.