The Weak Form Efficiency Finance Essay - Free Essay Example

Fama, after the publication of his world renowned article in May 1970 he is known as the godfather of the efficient market hypothesis (EMH). It all began when he submitted his Ph.D. thesis which entitled Efficient Capital Markets: A Review of Theory and Empirical Work. In that paper he defined the concept of accurate market efficiency. EMH allows that when there is new information available, some of the managers or the investors may overreact and some of them may underreact with the change in the new information. The main requirement of the EMH is to ensure that the managers (investors) reactions are random, which means the pattern of the results on net effect on market prices cannot be exploited by the managers (investors) for an abnormal profit for their company. So that it has random walk. Therefore if someone makes a profit from a share everybody can make a profit from it and if someone makes a loss then everybody makes a loss on that share. Fama came up with three forms of efficient market hypothesis. They are: weak form efficiency, semi-form efficiency and strong form efficiency. These three forms have different kinds of explanation how the markets run. 1- Weak Form efficiency- The price of the share cannot be predicted by the investors by analysing from the past results or by past series. It is quite i mpossible to gain abnormal profits by analysing the future price of the share, by any managers investment strategic or by historical results. The price of the share cannot have any series results, which means the results of the future price movement is predicted by the information which does not have any past results or past series. The price of the future result must have a random walk. Figure 1 show that it is quite impossible for the managers to predict the future price as the price the share is constantly moving. Fiqure-1 2- Semi Form Efficiency- It states that the price of the share cannot be manipulate by publicly available information in a very unbiased fashion, so that no extra profit can be made by the managers (investors) by studying all the public information. The adjustments of the information to the public must be reasonable size so that no one can manipulate the price of the share. If there is any such information then it will suggest that the information has been provided to manipulate the price of the share, which means the provider has acted in an inefficient manner. Figure 2 shows that the results after the public announcement. Fiqure-2 3-Srong Form Efficiency- It shares all the information with the public and with the investors but it makes sure no one can get any extra profit with the available information. There can only be a legal restriction on providing all the information to the public with the fear it may be manipulated by inside trading, or sharing the information. The market has to be fair so that the managers (investors) can earn extra profits for long period of time. In 1996 and in 2008 Dhaka Stock Exchange saw a massive blow in their Stock Exchange by not controlling the information, which resulted of inside trading. Figure -3 shows even though the results at the end are consistent but it is difficult for long term to predict for the managers (investors) all over the world. Figure- 3 PART -B Introduction The most important issue in finance research and interest is the efficiency of financial markets. When money is put in the market by the investors their aim is to generate the return on the capital invested as quickly as possible. Efficient market is where the market price is unbiased to estimate the true value of the investment. There are several key concepts: Market price and the true value do not have to be same every time. Examples Price of the outcome can be greater or less then the true value as long the deviation are random. Facts of the results of the deviation of the true value are random, which means there is a chance the value of the stock is undervalued or overvalued. No investors can be able to find the consecutive outcome of under or over value. Analysis Positive signs tend to proceed from good financial reports from a company. That is the reason why the technical patterns makes the move forward and anticipate the fundamental reports. Brock et al (1992), Technical analysis offers the investors with the opportunity of responding in real-time to a stocks behavior in which the investors do not have to wait for the next report from the company. Brock et al (1992), Fundamental analysis looks at the financial statement of the company .Therefore the investor can make a decision for the investment by the past financial statement. Efficient markets theory describe the price of an assets must show all the information that is available about the core value of the asset. Almost every form of the financial securities covers in efficient market theory (EMT) but except one kind of security which is being well discussed, shares of common stock in company. Theoretically, the investors get encouraged by the actuality of undervalued or overvalu ed stocks. That is the only reason there is a change in price of current value of future cash flow. Investment analysis looks at the mispriced stocks and that makes the market more effective which causes the price to yield the core value. The efficient market has to be random so the new information is random as well (favorable or unfavorable), which results in random walk in stock prices. This drives the investors not to invest heavily because there is no certainty of the returns as the price reflects the core value. In two ways the informational efficiency matters in stock prices. They are: investors care whether various trading strategies can earn returns and if stock prices reveal all the information accurately. To differentiate among the three forms of market efficiency it is easy to say that weak form stops technical analysis from being profitable, while semi-strong form stops the profitability of both technical and fundamental analysis, and strong form results, that even th ose with inside information of the company cannot expect to earn excess returns. Evidence for and against the Efficient Market Hypothesis Weak form efficiency A) The day of the week effect Cross (1973) and Gibbons and Hess (1981) elaborated that share prices fall on Mondays and rise on Fridays. However Dickinson and Muragu (1994) studied that the Nairobi Stock Exchange and found out that the day of the week effect does not affect the small stock exchange. Therefore it can be said the EMH is preferable in most of the stock exchanges in the world as it is not easy to predict by the outcome by the managers (investor) to invest in any stock exchange. B) The January small firms effect EMH face the challenge when January effects comes around, Keim (1983) sttes that US stock market studied that not only the return on stocks in January is high in relation to other months but the returns of small company stocks perform better in the month of January. Burton Malkiel, asserts Wall Street traders now joke that the January effect is more likely to occur on the previous Thanksgiving. Therefore it can be said even though the firms benefit from th e seasonal effect but there is no certainty with the actual result. The investors may think to invest more in December but they do not know the actual results. Semi strong Efficiency A) The price earnings effect Basu (1977) studied from 1957 71 the portfolio of different price earnings ratios ( P/E ) and the result was that the return on company stocks with low P/E ratios is much higher than the return on companies with relatively high P/E. In (1993) Fuller examined series of test but still got the same result but he found out that the result is not the same for the superiorly low company. Therefore it can be said though price earning effect can occur in stock market but it does not mean it will be for every low company. The investor will struggle to invest in that company because the low profile company results always different. B) The size effect Banz (1981) studied that the period of 1936 77 the excess return from holding stocks in the small company compared to the large company by 19.8 %. The firm size effect was as accurate as the firms betas in explaining the excess return which clearly contradict with the EMH. However some author urged that the r esults from the small firms are too low to evaluate their historical results. Strong Form Efficiency A) The Directors/Mangers share purchase Jaffe (1974) studied that the managers and the directors earn excess return from their trade, with all the information of inside which is contradictory with strong -form EMH. After the early 2000 scandal the US government and the NASDAQ implemented that the directors of the company has to be independent so that no information on inside trading. As the directors are independent there is no chance of getting any inside knowledge about the company by the investors. B) Information content of analysts forecast Elton (1986) studied that excess return can be earn once due allowance had been made for risk by buying upgraded stocks or stocks that were in a higher classification and selling downgraded stocks or stocks in a lower classification. However it needs a certain warranty before the trading on a brokers recommendation. Therefore the investors need to accelerate their trade because there is no certainty with the information. Conclusion- In fundamental way the prices may differ from long and slow movement but in two ways EMT is still useful. 1) For shorter period, examples as days, weeks and months. EMT can explain the movement of stock price changes with considerable evidence. That is the answer of stock prices to all new information reasonably the change in the core value of the assets.2) EMT serves as a scale for how prices should move if capital investment, funds, assets are to be allocated efficiently. All the outcomes depend on the transparency of information, the effectiveness of regulation and the prospect of rational arbitragers will drive out noisy investors. In fact the informational efficiency of stock prices moves across markets to markets and country to country. Whatever the outcomes of capital markets, there is no better alternatives of allocating investment capital. In fact most countries have recognized it for their future goal. Critics may say that an EMH passionate would not pick up a hundr ed dollar note from the road because according to the EMH, that note cannot be there, either the note is fake or somebody must already have picked it up. EMH can make investors miss some investment opportunities on their investment, but it will also protect the investors from hidden and unknown risks.