EMH Theory for Management Assignment

Introduction

EMH Theory Management Assignment  is said to be efficient if at any given time, in a liquid market, all available public or non public information is reflected through the stock prices. This EMH Theory Management Assignment was espoused from a PhD dissertation in the 1960s by Eugene Fama. Therefore, according to the theory the market prices reflect the present value of stocks and there is actually no opportunity to make extra or excess profit using the present information. To put it in simple words, according to the EMH, on the stock exchanges, the stocks trade at a fair value. According to this theory, it gets essentially impossible for the investors to either sell stocks at an inflated price or buy an undervalued stock to gain excessive profits within a short period of time. Through this method, investors can only earn high profits or returns by purchasing riskier investments.

After developing the theory in the 1960s, (Fama, 1970) presented its three type form. The three versions of this hypothesis are – weak, semi strong and strong, each explained at length below –

Weak form efficiency – This form suggests that all stocks present and completely reflect presently available security market information. It essentially dictates that the future direction of security prices has no relationship with the volume data and the past price. It also states that by using technical analysis excess returns cannot be achieved. Putting it in simple words – in the long run, excess returns cannot be earned by using investment strategies using old share prices or other data. There is actually no pattern to assert prices and therefore future movement of price is directly proportional to information which is not contained in the series of prices. Therefore, prices follow a “random path”. This soft EMH merely points the fact that it doesn’t need equilibrium prices but only that the participants in the market (investors) will not be able to gain from the inefficiencies prevailing in the market. However, in some cases, it has been observed that not all price movement is random. Many studies have observed that stock markets trend for weeks or longer (Saad, 1998). It has also been observed that the relation between the time period of trending and its degree is positive.

Semi strong efficiency – This form assumes that based on the new public information, stock prices gets adjusted rapidly. It also states that security prices have factored themselves as per the trend in the available market and according to the non market public information. In this form excess return on investment cannot be earned by trading on this new public information. It also contends that neither technical analysis nor fundamental analysis will be able to earn excess returns. To test this form, there must be a reasonable size of adjustments to unknown news which should also be instantaneous. The upward or downward change should also be looked after. The presence of any such adjustment would imply that the investors had shaped the information in a bias manner and that it is inefficient.

Strong efficiency – This form assumes that the stock prices completely reflect private and public information and that no one will be able to earn excess gains in this form of the EMH.  It implies that future prices are well predicted accurately and the random walk happens only because of false or erroneous prediction by the market research players. It also states that there is no monopoly in access to the relevant information. There is an assumption of a perfect market and that excessive returns are not possible to achieve in a consistent manner. Also, if there is any legal barrier to withholding any information, then strong efficiency is impossible.

This EMH Theory Management Assignment will essentially discuss the theory and relevance of the EMH in detail and present different literature written on the same topic to have a better understanding of the concept, background and feasibility of the same. Furthermore, arguments for and against the EMH will be pitched against each other along with empirical evidence and academic references to have a complete understanding of the concept and also to explore strengths, weakness and opportunities in business development of the same.

 

The emh discussion

This EMH Theory Management Assignment can be easily summed up in a humorous way as well: Two investors are walking down a street and they come up with a $100 note. Before the first investor could reach down and grab it, the second investor stops him and remarks if it was a genuine note, any other investor would have picked it up. This hypothesis relies on the speedy transfer of information. It does not make any sense for the second investor to disregard the note; however, it makes sense when hundreds of other investors have walked past and ignored it. So, the most important consequence of the EMH is that all investment tips are of no use, if they have been reflected in the stock prices already.

The EMH Theory Management Assignment does not, essentially, state that all market players will be rationale or all prices will be correct. There is substantial evidence that the market players suffer from biases in their processing of information and they are also far from being rational. This, however, does not mean that prices will be correct if their setting was determined by rational profit maximising investors. For instance, assume that the stock prices are determined rationally and presented as the discounted present value of all future transactions of cash flows. This is arbitrary as future transactions of cash flow management can only be predicted and can never be known with precision. There is always going to be errors in the prediction of future earnings, sales and profit. Furthermore, equity risk premiums have an unlikely nature to be stable for a long time. It is because of all the aforementioned reasons that prices will be wrong all the time. EMH, thus, only implies that we can never be sure if the prices are too high or too low. Some market players may determine whether they are too high or too low but sometimes this judgement can produce erroneous results.

Mispricing can, more often than not, incorporated with complex financial investment market. This gets more complex when loans that underlie the derivative are not interpreted correctly. There is, however, no doubt that it was mispricing of mortgage backed securities that widened the scope of the financial crisis across the globe. The classic bubble of the financial crisis was a traditional case where the mispricing of the real estate in securing the mortgage was done. The market was not rational and they (investment bankers and mortgage originators) worked on exponential profit incentives.

The emh and random walk

All forms of the EMH which have been discussed in the initial part of this paper espouse that prediction of market prices is not possible. Much of the literature surrounding the topic lay focus on the Random Walk Hypothesis which is nothing but a statistical description of unpredictable price changes. “The price change must be random if and when market price completely incorporates any expectation and information of all associated market participants” (Samuelson, 1965). It underlines that fact that true news is random and it cannot be predicted from past news – as prices change as per the delivery of a new information. Therefore, it is stated that in an informationally market, price change in unpredictable. It, however, does not mean that stock market is whimsical based on differing and random price movement. The term, random, implies that the market is well functioning and efficient and not essentially irrational one. The earliest work on this hypothesis was provided by Bachelier, (1900) where he concluded that a random path was followed by commodity prices and this was corroborated from the works of Working, (1934), Kendall, (1953) and Cowles and Jones, (1937). The common factor among all these studies was that the correlation between all the successive changes was zero.

See more Currency Market Analysis Assignment

Alternative technique was also used to get complicated patterns in exploratory markets. Granger and Morgenstern (1963) used spectral analysis as one of the techniques; however, they were not able to decipher any repeatable and dependable patterns showcased in price movements of stocks. Serial correlation coefficients were measured on a daily and monthly basis in nine countries by Solnik, (1973) where he concluded that investment strategies which are profitable could not be formulated just on the basis of small dependencies which were found.

Critical eveluation of the emh

There have been many arguments against the EMH theory. Many market anomalies, such as the January Effect espouses that there was evidence that as compared to other months, the month of January yielded higher returns. According to this effect, the price of small‐cap stocks will rise oddly during the first few weeks or days of trading in any new year (Pietranico & Riepe, 2004).

Asymmetry of Information is one solid requirement of the EMH theory and it essentially states that the new information should be able to circle around the investors’ circle at a random pace for semi strong EMH form to be possible. In fact, Chen, (2005) goes on to state that generation of a good information could turn out to be very costly and as such it can also rapidly lose value as more and more people start to learn it. Therefore, vested interests look to stop the widespread sharing of the information. Many studies show that any good information tends to be collected by investors, rather hoarded and there have been premeditated attempts at spreading misinformation from one investor to the other (Akerlof, 1975). However, many empirical records suggest that any news incorporated within ten minutes despite any disparity which has access to investors to information exist (Patell & Wolfson, 1984).

Therefore, this issue of how the market is able to adjust new news and incorporate the new prices accordingly even when the information is asymmetrical. This concept has also interested many studies.

According to the EMH theory, stock market movements which are substantial should not be constant but be rare and they should also be not severe because of the presence of normally distributed randomness. Ormerod, (2005) rightly points it out when he says, “failure & extinction is not the exception but the statistical norm” when there is a discussion about how brutal market crashes are the basic feature of cut throat markets.

EMH Theory for management assignment

Sharpe (1970) has contributed to the theory of the Capital Asset Pricing Model (CAPM), which also depends a lot on the EMH theory and he highlights the implications of many assumptions.

When the CAPM model was used to ascertain risks, the value stock gave higher returns, which implies that the stock represented inefficiency. It was also observed that investors could capitalise on small markets by directing stocks and get higher returns on portfolios. Therefore, it can be stated that the model of CAPM is indeed insufficient and flawed in representing or measuring risks. Companies regularly employ techniques to interpret risk measures which amplify the argument of BETA in the CAPM model.

This strongly states that just like CAPM, EMH is fits the data by luck for some price movements. There are, however, two alternatives to the EMH theory: Behavioural Finance and Econophysics. Behavioral Finance has the background of cognitive psychology and Econophysics applies its theories which initially had been developed by physicists so that problems of Economic can be solved. This includes stochastic elements and uncertainties as well along with other non linear dynamics.

Behavioural Finance states that investors concentrate on what another investor does and the secondary importance is taken by the fundamentals of their own private. On the other hand, Econophysics goes on to say essentially that “random walk” of asset prices is not random in actuality. It says that it actually is a non linear power distribution. Omerod, (1998) reports that a fractal system is actually similar to any biological system and this is the reason why it is able to depict a behaviour which is deemed chaotic and is also coupled with scaling which is allometric.

Without a doubt, the studies revolving the EMH have made the understanding of the securities market better and invaluable; however, there is a growing disparity with the theory presented. The recent literature including criticism of the EMH is gaining momentum, especially after the financial crisis. As it is clear that the market responds to the new information but information alone does not affect security valuation.

Conclusion

The EMH trial will go on for years to come and it is well expected that the result may as well be a compromise between different schools of thoughts. This paper contends that the knowledge of the stock organizational behaviour would be best brought further by incorporating a multidisciplinary approach that uses both the qualitative as well as quantitative research methods. This paper also does not imply that the EMH theory be abandoned but suggests that the popular EMH theory be redefined to include both the popular aspects – speculative and psychological – which are measured to ascertain the stock markets. The recent insight into the speculative aspect of the EMH has opened up a field of research areas for the academics. Also, the EMH and Behavioural Finance theories go hand in hand are not competitive in nature and the same should not be regarded as such at all. This is so because Behavioural Finance draws insight into expectations formations through which many valuations are ascertained. This concept does not argue that the market is beatable from the biased behaviour of the investors. Policy makers should also take into consideration the point that financial markets should consider risk premiums which are also influenced by environment factors as well.

References

  •  Akerlof, G., (1970), ‘The market for ‘Lemons’: Quality, Uncertainty and the Market
  • Mechanism’, Quarterly Journal of Economics, vol. 84, pp. 488‐500.
  • Cowles, A., & Jones, H. (1937). Some A Posteriori Probabilities in Stock Market Action. Econometrica 5, pp. 280-294.
  • Chen, J., (2005). The Physical Foundations of Economics, World Scientific Publishing Co., London.
  • Fama, E., (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. In: Journal of Finance, 383-417.
  • Granger, C., & Morgenstern, O. (1963). Spectral Analysis of New York Stock Exchange Prices. Kyklos 16:1, pp. 1-27.
  • Kendall, M. (1953). The Analysis of Economic Time Series, Part I: Prices. Journal of the Royal Statistical Society 96, pp.11-34.
  • Krugman, P., (2009). How Did Economists Get It So Wrong?. New York Magazine.
  • Malkiel, B. G., (2011). The Efficient Market Hypothesis and the Financial Crisis.
  • Ormerod, P., (2005), Why Most Things Fail Evolution, Extinction & Economics, Faber and Faber Ltd, London.
  • Pietranico, P. & Riepe, M.W., (2004), ‘The January Effect Revisited’, Journal of
  • Financial Planning, vol. 17, pp. 26‐29.
  • Patell, J.M. & Wolfson, M.A., (1984), ‘The Intraday Speed of Adjustment of Stock
  • Prices to Earnings and Dividend Announcements’, Journal of Financial Economics, vol. 13, pp. 223‐252.