ASSIGNMENT No. 1
Course:
Financial Management (8513)/9521
Semester:
Autumn 2018 Level: MBA (3½ Years / 2½
Years) / M. Com.
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Q.
1
Explain
the concept of efficient market hypothesis with example. Explain with examples
it three types. (20)
Ans
The Efficient Market Hypothesis (EMH) is an
investment theory whereby share prices reflect all information and consistent
alpha generation is impossible. Theoretically, neither technical nor
fundamental analysis can produce risk-adjusted excess returns, or alpha,
consistently and only inside information can result in outsized risk-adjusted
returns. According to the EMH, stocks always trade at their fair value on stock
exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
As such, it should be impossible to outperform the overall market through expert
stock selection or market timing, and the only way an investor can possibly
obtain higher returns is by purchasing riskier investments.
The efficient-market
hypothesis (EMH) is
a theory in financial economics that states that asset prices fully reflect all
available information. A direct implication is that it is impossible to
"beat the market" consistently on a risk-adjusted basis since market
prices should only react to new information.
The efficient-market hypothesis was developed by Eugene Fama who
argued that stocks always trade at their fair value, making it impossible for
investors to either purchase undervalued stocks or sell stocks for inflated
prices. As such, it should be impossible to outperform the overall market
through expert stock selection or market timing, and that the only way an
investor can possibly obtain higher returns is by chance or by purchasing
riskier investments. His 2012 study with Kenneth French supported
this view, showing that the distribution of abnormal returns of US mutual funds
is very similar to what would be expected if no fund managers had any skill a
necessary condition for the EMH to hold.
There are three variants of the hypothesis: "weak",
"semi-strong", and "strong" form. The weak form of the EMH
claims that prices on traded assets (e.g., stocks, bonds, or
property) already reflect all past publicly available information.
The semi-strong form of the EMH claims both that prices reflect all publicly
available information and that prices instantly change to reflect new public
information. The strong form of the EMH additionally claims that prices
instantly reflect even hidden "insider" information.
There is no quantitative measure of market efficiency and testing
the idea is difficult. So-called "effect studies" provide some of the
best evidence, but they are open to other interpretations. Critics have blamed
the belief in rational markets for much of the late-2000s financial crisis. In response, proponents of
the hypothesis have stated that market efficiency does not mean not having any
uncertainty about the future; that market efficiency is a simplification of the
world which may not always hold true; and that the market is practically
efficient for investment purposes for most individuals
Although it is a cornerstone of modern financial theory, the
Efficient Market Hypothesis (EMH) is highly controversial and often disputed.
Believers argue it is pointless to search for undervalued stocks or to try to
predict trends in the market through either fundamental or technical analysis.
While academics point to a large body of evidence in support of
EMH, an equal amount of dissension also exists. For example, investors such as Warren Buffett have consistently beaten
the market over long periods of time, which by definition is impossible
according to the EMH. Detractors of the Efficient Market Hypothesis EMH also
point to events such as the 1987 stock market crash,
when the Dow Jones Industrial
Average (DJIA) fell by over 20% in a single day, as evidence
that stock prices can seriously deviate from their fair values.
Example
Suppose a company ABC is a mutual fund company with a total fund
of $ 10 million invested in a stock exchange, In order to get a return on fund
[Investment], management of the company uses forecasting and valuation
techniques to aid in decision making. At the end of the year, the company makes
1% gain of $100,000 from the investment after excluding transaction cost.
According to EMH, there is no need to have forecasting and valuation techniques
rather risky stocks should be considered for gain in investment.
Weak-form efficiency
In weak-form efficiency, future prices cannot be predicted by
analyzing prices from the past. Excess returns cannot be earned in the
long run by using investment strategies based on historical share
prices or other historical data. Technical analysis techniques
will not be able to consistently produce excess returns, though some forms
of fundamental analysismay
still provide excess returns. Share prices exhibit no serial dependencies,
meaning that there are no "patterns" to asset prices. This implies
that future price movements are determined entirely by information not
contained in the price series. Hence, prices must follow a random walk. This
'soft' EMH does not require that prices remain at or near equilibrium, but only
that market participants not be able to systematically profit
from market 'inefficiencies'.
and that, moreover, there is a positive correlation between degree of trending
and length of time period studied (but note that over long time periods, the
trending is sinusoidal in
appearance). Various explanations for such large and apparently non-random
price movements have been promulgated.
There is a vast literature in academic finance dealing with the
momentum effect identified by Jegadeesh and Titman. Stocks that have performed
relatively well (poorly) over the past 3 to 12 months continue to do well
(poorly) over the next 3 to 12 months. The momentum strategy is long recent
winners and shorts recent losers, and produces positive risk-adjusted average
returns. Being simply based on past stock returns, the momentum effect produces
strong evidence against weak-form market efficiency, and has been observed in
the stock returns of most countries, in industry returns, and in national
equity market indices. Moreover, Fama has accepted that momentum is the premier
anomaly
The problem of algorithmically constructing prices which reflect
all available information has been studied extensively in the field of computer
science.
In its third and least rigorous form (known as the weak form),
the EMH confines itself to just one subset of public information, namely
historical information about the share price itself. The argument runs as
follows. ‘New’ information must by definition be unrelated to previous
information, otherwise it would not be new. It follows from this that every
movement in the share price in response to new information cannot be predicted
from the last movement or price, and the development of the price assumes the
characteristics of the random walk. In other words, the future price cannot be
predicted from a study of historic prices.
Each of the three forms of EMH has different consequences in the
context of the search for excess returns, that is, for returns in excess of
what is justified by the risks incurred in holding particular investments.
If a market is weak-form efficient, there is no correlation
between successive prices, so that excess returns cannot consistently be
achieved through the study of past price movements. This kind of study is
called technical or chart analysis, because
it is based on the study of past price patterns without regard to any further
background information.
If a market is semi-strong efficient, the current market price is
the best available unbiased predictor of a fair price, having regard to all
publicly available information about the risk and return of an investment. The
study of any public information (and not just past prices)
cannot yield consistent excess returns. This is a somewhat more controversial
conclusion than that of the weak-form EMH, because it means that fundamental analysis
– the systematic study of companies, sectors and the economy at large – cannot
produce consistently higher returns than are justified by the risks involved.
Such a finding calls into question the relevance and value of a large sector of
the financial services industry, namely investment research and analysis.
If a market is strong-form efficient, the current market price is
the best available unbiased predictor of a fair price, having regard to all
relevant information, whether the information is in the public domain or not.
As we have seen, this implies that excess returns cannot consistently be
achieved even by trading on inside information. This does prompt the
interesting observation that somebody must be the first to
trade on the inside information and hence make an excess return. Attractive as
this line of reasoning may be in theory, it is unfortunately well-nigh
impossible to test it in practice with any degree of academic rigour.
Semi-strong-form efficiency
In semi-strong-form efficiency, it is implied that share prices
adjust to publicly available new information very rapidly and in an unbiased
fashion, such that no excess returns can be earned by trading on that
information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques
will be able to reliably produce excess returns. To test for semi-strong-form
efficiency, the adjustments to previously unknown news must be of a reasonable
size and must be instantaneous. To test for this, consistent upward or downward
adjustments after the initial change must be looked for. If there are any such adjustments
it would suggest that investors had interpreted the information in a biased
fashion and hence in an inefficient manner.
In a slightly less rigorous form, the EMH says a market is
efficient if all relevant publicly available information is
quickly reflected in the market price. This is called the semi-strong form
of the EMH. If the strong form is theoretically the most compelling, then the
semi-strong form perhaps appeals most to our common sense. It says that the
market will quickly digest the publication of relevant new information by
moving the price to a new equilibrium level that reflects the change in supply
and demand caused by the emergence of that information. What it may lack in
intellectual rigour, the semi-strong form of EMH certainly gains in empirical
strength, as it is less difficult to test than the strong form.
One problem with the semi-strong form lies with the identification
of ‘relevant publicly available information’. Neat as the phrase might sound,
the reality is less clear-cut, because information does not arrive with a
convenient label saying which shares it does and does not affect. Does the
definition of ‘new information’ include ‘making a connection for the first
time’ between two pieces of already available public information?
Strong-form efficiency
In strong-form efficiency, share prices reflect all information,
public and private, and no one can earn excess returns. If there are legal
barriers to private information becoming public, as with insider trading laws,
strong-form efficiency is impossible, except in the case where the laws are
universally ignored. To test for strong-form efficiency, a market needs to
exist where investors cannot consistently earn excess returns over a long
period of time. Even if some money managers are consistently observed to beat
the market, no refutation even of strong-form efficiency follows: with hundreds
of thousands of fund managers worldwide, even a normal distribution of returns
(as efficiency predicts) should be expected to produce a few dozen
"star" performers.
Example
For example,
if the current market price is lower than the value justified by some piece
of privately held information, the holders of that information
will exploit the pricing anomaly by buying the shares. They will continue doing
so until this excess demand for the shares has driven the price up to the level
supported by their private information. At this point they will have no
incentive to continue buying, so they will withdraw from the market and the
price will stabilize at this new equilibrium level. This is called the strong
form of the EMH
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