Concepts of Market Efficiency and Empirical Approaches to Testing

¶ … Market Efficiency and Empirical Approaches to Test for it

A review and discussion of market efficiency

A financial market is efficient with respect to information item, if the new information has fully influenced the market prices. In an efficient market, when a new information is made available its impact is said to be instantaneous or rapid and unbiased to the financial assets' current market prices.

There are three different hypotheses that have been formulated to try and explain market prices, in respect to what kind of information is availed to the market. The weak version of efficient market hypothesis suggests that the changes in market prices are in respect to all the information that the public has had in the past. The semi-strong form of hypothesis suggests that the current prices in the financial market is a reflection of all the information that the public, and that the introduction of new information is also bound to change these prices. The strong form hypothesis of efficiency market on the other hand suggests that prices in the financial market are a full reflection of the information that is already known to the market participants.

This is essay is a review and discussion of market efficiency and empirical approaches to test for it. It initially begins with an empirical review of efficiency market followed by a review and discussion of the efficiency market hypothesis. The third section of this essay looks at the efficiency markets from a risk and return perspective, the third section re-examines some empirical tests for semi-strong efficiency. Before concluding this study spells out a critical analysis of risk and return perspective.

The concept of efficiency markets -empirical review

Based on observation and experiment it is without doubt that the subject of finance is also built on the concept of efficiency. According to Fama, (1970) and other financial analyst they have referred to efficiency market as a market in which the financial assets prices are determined or affected by any relevant information that relates to these financial assets. In his studies Samuelson (1965) noted that the prices of financial assets is a reflection of the present, past and even future events, however this events show no precise relation to changes on prices of financial assets, he further goes on to say that thou the market doesn't predict the price changes, it can mathematically evaluate the likelihood of these price changes occurring.

The concept of efficiency market has various hypotheses which can be viewed as being consistent with the random walk model which tends to proof that the financial assets price changes have no predictable bias pattern, and also the same model can be applied for better understanding of price formation in the competitive markets. Finance has applied this model on consecutive returns that are independent to prove that in a series of financial asset prices that occur at close interval it is difficult to identify any systematic effect that might be affecting the price movements, as the data observed shows a pattern that is equal to a wandering series.

Contrary to the earlier definition given on the concept of efficiency market; Burton (1987) contradicts by writing that, on theory a market that is efficient is one which by using the information available otherwise known as information efficiency is likely to fail in generating abnormal profits on the financial assets of the market. In his studies he ads on that a market can only be deemed to be efficient if it posit a model for returns and that the test for market efficiency is also a test for asset pricing model and market behavior (Burton, 1987).

The efficient market hypothesis

There are three forms of hypothesis that exist in the efficiency market that are namely the; weak, semi-strong and strong versions of hypothesis. Same as the concept of efficiency market these hypothesis were initially expressed on a thesis termed as "the theory of speculation," which was written in 1900 by mathematician Louis Bachelier who was a Frenchman pursing a PhD in mathematics at that time. These hypotheses had being widely ignored since Bachelier formulated them and various economists cited that the main problem with them was that it claimed financial assets, which have low prices to earnings do generate higher returns than other financial assets. These later changed in the 1960's after the hypotheses were reviewed and refined by other prominent economists who provided substantial evidence to support them. Among such prominent economist were Paul Samuelson who wrote the evidence for a version of the EMH, Eugene Fama who in his studies rooted for the random walk hypothesis and Paul Cootner whose work also refined the theory so as to become applicable.

Both of these version of hypotheses claims that the financial market is "information ally efficient," this means that based on the fact that information pertaining to investments in the financial market are usually available to the general public when investments are being made no investor can get returns from his or her investments that is highly in excess of the market's average returns on a risk-adjusted basis. This fact is consistent to the earlier argument by Burton (1987) who claimed that on theory a market that is efficient is one which, by using the information available is likely to fail in generating abnormal profits on the financial assets of the market.

Critics of the efficiency market hypothesis link them to a rational market rather than an efficient market and they further blame such ideas as the contributing factors to the financial crisis witnessed in between 2007 and in the early part of 2010. This criticism has also been applauded by various economists who also blame the rational behavior of the investment public for the recently witnessed financial meltdown. However the advocates of the hypothesis have lodged their defense arguing that relating efficient market hypothesis with market stability is unwarranted and that when information available to the public is unstable, the market can as well be unstable.

Each of these hypotheses has different impact on how the financial market operates and it is important to note that the EMH require market participants to have rational expectations i.e. whenever new information is availed to the market participants should change their expectations consistently with the new information. Investors in the financial market have been observed to either overreact or under-react after receiving new information, however the EMH only require these reactions to be random and in line with a normal distribution pattern so as to avoid making abnormal profits.

The weak form of efficiency market

The weak version of efficient market hypothesis is based on the fact that the prices of financial assets such as bonds, stocks or property are an indication of all the information that the public has had in the past.

Based on experiments and observation conducted by Beaver (1968) he concluded that among the three hypotheses of efficiency market; the weak form of efficiency market 'holds more water 'than the rest, this in other terms means that results of the empirical analysis conducted are full in support of this hypothesis unlike the other two hypothesis.

The weak version of EMH has some implications on market operations that that include; future market prices cannot be predicted using prices or information from the past, also it will be impossible to earn abnormal returns in the long run using historical data or market prices as an investment strategy. This hypothesis further claims that technical analysis techniques are unlikely to generate excess returns unlike fundamental analysis which can. Also the market prices show no signs of serial dependencies, thus there is no set pattern for these prices. Prices in the financial market are largely determined by relevant information and not the price pattern; consequently this means that market prices follow the random walk model hypothesis (Fama et al. 1969).

An empirical test for weak form of efficiency market hypothesis tries to look at the relation between the information the public has had in the past and the pattern of financial markets activities. The test tries to prove whether financial markets are information ally efficient and that market prices rapidly adjust to information which the public has had in the past.

The semi-strong form of efficiency market

The semi-strong form of hypothesis argues that prices in the financial market is a reflection of all the information that the public already has and that these prices change immediately when a new information is availed to the public.

The implication of the semi-strong form of EMH to the financial market is that market prices rapidly adjust in an unbiased manner to new and relevant information that the public has. The empirical studies conducted on semi-strong hypothesis try to evaluate the rate of adjustments of market prices to new information that has been made available to the investing public; these studies provide evidence to prove how market prices react rapidly and in unbiased manner to new information such as earning announcements and stock splits.

An empirical test for semi-strong efficiency tries to look at the relation between the pattern of how information arrives and the pattern of financial markets activities. The test tries to prove that indeed the financial markets are information ally efficient and that market prices rapidly adjust to new information relevant to the market

The strong form efficiency market

The strong form hypothesis of efficiency market asserts that prices in the financial market are a full reflection of the information that is already known to the buyer, sellers and even the market brokers. It is also important to note that other literatures note that this hypothesis claims that prices in the financial market are a reflection of insider or hidden information.

There is substantial evidence against the strong-form of EMH because of the availability of legal laws that prohibit private information becoming public. Consequently this means that market prices do not reflect all information market participants have because there are laws in place that prohibit insider trading (Maloneya and Mulherin, 2003).

An empirical test for strong form of efficiency market tries to look at the relation between the information market participants could have and the pattern of financial markets activities. The test tries to prove whether financial markets are information ally efficient and that market prices rapidly adjust to "insider" information.

Efficiency markets from a risk and return perspective

Referring to empirical studies conducted by researchers and investors' they have criticized the efficiency-market and its' hypotheses. According to Jensen (1969) and other behavioral economist, they have all refuted the claim that information is the cause of imperfection in the financial market, but rather they have suggested that imperfections in the financial markets is related to the cognitive biasness of investors, like overreaction, overconfidence, information bias, representative bias and other human errors in terms of reasoning and information processing. The errors in reasoning lead investors to avoid or take risk unknowingly and also buy financial assets with low returns; an example of this is investors avoiding value assets or stocks and instead buying growth stocks at expensive prices and risk-free, thereby opting for low returns as opposed to investors who will make high returns from bargains in neglected value assets or stocks that are risk based.

The efficiency market contradicts again in terms of returns as it claims returns on financial assets reverse over a long pattern i.e. those whose assets had poor returns over a period of time would have high returns over a similar period of time on the same assets or stocks. This claim by efficiency market is that investors whose stocks have low returns over a period of time have a much higher average return than those investors whose stocks posted higher return over the following period of the same number of years. According to Obaidullah (1990) empirical studies refutes this assumption on the fact that beta cannot account for this difference in average returns and that investors with low returns would require higher betas than investors with high returns to justify the differences in returns.

On the other hand an investor cannot rely on new information to determine on whether to invest in assets with high risk or low risk, as such a decision is based on many factors that include amount of capital at his or her disposal, aim of investment, whether the investor is a risk taker or not among others.

Empirical test for Semi-strong efficiency

Referring to studies conducted by Scholes (1972) the semi-strong form of EMH asserts that historical market prices do not have an influence on future market prices, once the current market prices have been used as information or as an explanatory variable. This means that future patterns of market prices is only influenced by newly acquired information that was unpredictable at the moment. Another assertion by this hypothesis is there are no arbitrage opportunities.

Empirical test for semi-strong efficiency are meant to test these assertions or consequences of the hypothesis. This empirical test tend to prove whether the assumption of random work hypothesis in semi-strong form is indeed correct, as other studies have shown that there are predetermined patterns and seasonal trends which exist on market prices. Studies also show that the returns recorded at the financial market be it on a daily, weekly or monthly basis all exhibit a distinct pattern like seasonal effects on stock prices like holidays, day of the week effect, month of the year effect and hourly effects on market prices. Furthermore the use of technical analysis by stock brokers to predict market prices of individual financial assets over a specific period of time, tends to prove that random walk hypothesis is incorrect as stock prices can move in a specified or predetermined pattern.

An empirical test for semi-strong efficiency tries to look at the relation between the pattern of how information arrives and the pattern of financial markets activities. The test tries to prove that indeed the financial markets are information ally efficient and that market prices rapidly adjust to new information relevant to the market.

According to a test carried out on the random walk model hypothesis that calculated the difference of two consecutive market prices in natural logarithms, which is the stock return followed by a computation of correlation with different lags. The test showed that there is serial dependence between two consecutive markets returns i.e. A two days old return can predict today's stock returns. This result differs with the random walk model hypothesis (George, 1970).

Another empirical test carried out on the correlation between new information and market activity showed that there is relative weak relation that exists between new information and market prices. This could be attributed to the fact that information may be specific to a firm and it can't have a big impact on the aggregate financial stock market price index. Secondly public information news doesn't have a big significance of particular news information. Thirdly an emerging market casts down on the validity of the model regarding to information.

A critique of the risk and return perspective

Referring to studies conducted by Scholes (1972) he points out that usually investments available in the market are not without risk and to the investor it is not a question of whether there is risk involved but rather what rate of risk the investor is exposed to. Risk exists when the decision maker is able to estimate the probabilities associated with certain outcomes using objective probability distribution. In so far as risk cab be identified then it is possible to a certain with some reasonable degree of accuracy the expected inflows from an investment.