Eugene Fama's efficient market hypothesis and the random walk theory

Market Efficient Respect Set Information Impossible Makes Abnormal Profits

Market Efficient

In his work, Fama argued that given the massive use of resources by the brokerage firm to conduct studies on trends in the industry, the effects of changes in interest rates on corporate balance sheets and expectations of managers and/or political analysts of the companies should be able to systematically beat a generic portfolio with the same risk characteristics.

Since, according to Fama, professional in every situation, the analyst has a fifty percent chance of beating the market; although its specific capabilities did not exist he would beat a lot of the market. The analyst did "help" the market to be efficient if all the investors, in fact, would hold portfolios composed of stock indices, would open up significant opportunities for professional traders to take advantage of the situation. But the movement of traders to that "new market" would mean that the advantage disappears, confirming once again, thus the "Efficient Market Theory" of Fame.

The analysis of Fame tended to confirm, then, the "Random Walk Theory" of stock prices already investigated by authors such as Louis Bachelier in 1900, Holbrook Working in 1934, Alfred Cowles in 1937, Clive Granger and Oskar Morgenstern in 1963, and Paul Samuelson in 1965. Added to their fame by a more rigorous statistical approach-mathematical exposition and a major strength: it was a new revolution in finance. Fame makes three different assumptions about market efficiency.

Financial markets: liquidity, arbitrage and speculation

One of the main reasons for the existence of stock markets is the liquidity, understood as the ease with which financial assets are transferred loss of value. (Pagano, M. And A. Roell 1996) Thus, the stock market facilitates the exchange of such assets, as without it would be necessary to incur high financial costs and time for a transaction. Therefore, the stock market reduces these transaction costs in large hand, provides a quick, accurate and free of the real value of assets financial exchange in it. (Zarowin 1990)

Not all assets that are traded in financial markets have the same liquidity, a way to see what assets are more liquid and the least is to compare the difference between the buyer and the average bid price offered by all financial intermediaries. The smaller this difference is more liquid assets, while if it is large will mean that the lack of liquidity makes running a greater risk intermediary because if it buys us take time to get rid of also, during which you can depreciate by the intermediary incurs a loss. (Rouwenhorst 1998)

In financial markets there are a number of operators that seek to acquisition of an asset in a given market to sell it immediately in another market at a higher price. They are known as arbitrageurs because the operation above is referred to arbitration. (Pagano, M. And A. Roell 1996) This operation carries no risk because the asset purchases and sales take place instantaneously. Indeed, the existence of competing arbitrageurs seeking continuously these opportunities to make a profit without risk, say the price of an asset is the same in virtually all financial markets in the that is listed (this is known as the "law of one price"). The small differences observed among these are due to transaction costs that do not cost advantage of them and act as a limit for the completion of arbitration. The transaction costs are highly dependent on the physical differences between the products traded on a market (hence financial markets are much smaller than in the physical commodity markets) and market size (the number financial assets that are traded daily is very large). (Pagano, M. And A. Roell 1996)

For all these reasons, the existence of competition among arbitrageurs is essential for the market to become efficient. In fact, a market where there are no arbitrage opportunities can be said to be efficient. It should be borne in mind that an important factor to promote competition in the markets lies in the homogeneity of the goods exchanged, and since financial assets are very homogeneous so facilitates competition in financial markets and therefore their efficiency. (Thomas 1989)

Unlike the arbitrageur who only owned the asset for an instant, the speculator keeps in his possession for some time in order to benefit from a favorable future variation in price in return for which is at risk. The importance of arbitration over speculation is that, in many cases, Speculators anticipate price changes without perfect information. In line with this, commented that market participants react quickly to events that provide useful information. (Tonks and Webb 1991)

First reaction those that access to such information, making them take advantage and benefit from being the first to take positions on what is coming (this is the concept of "information asymmetric "). Then, the other participants react to such information, not because they know it, but because the inferred variations in prices caused by participants who have access to it. (Smith 1987)

This process is called signaling. Purchases and sales of financial assets and thus altering their prices are the mechanism by which the information contained in the signals is reflected in the prices. For example, changes in dividend policy usually followed by the company or in its capital structure provide signals to the market this should be interpreted and reflected in the price of the shares of the company. Well, speculators are continually seeking new information that to establish whether the securities will rise or fall in the future to know what should be the current decision: buy or sell. (Stigler 1987)

Competition between them is brutal, because that first guesses will be the most wins, this means that sometimes you get to break the law in search and pursuit of insider trading. Please note that the benefits the speculators are the result of cost, time, effort and money spent collect, analyze and use information to negotiate with advantage. (Taylor et al. 2000) The more recent more useful information, but also more difficult and expensive to obtain. As noted, the financial market participants are interpreting the information continuously available. (Rouwenhorst 1998)

In general, the process of interpret the information involves using the "inductive reasoning" that is, using a specific situation to draw general conclusions. The competition for properly interpret information and make the prices of financial assets is good estimates of the future.

The idea of efficient market

In light of everything mentioned in the previous section, it says that a market values?

is efficient when the competition between the different actors involved I n it, guided by the principle of profit maximization leads to a situation equilibrium in which the market price of any security is a good estimate of its theoretical price or intrinsic (present value of all expected cash flows). Put another way, the prices of securities traded in markets efficient financial reflect all available information and adjust quickly total new information. It is also assumed that the information is free. (Petri 2004)

If all shares are fully valued, investors will get a return on their investment that will be appropriate for the level of risk assumed, without matter what the securities purchased. That is, in an efficient market all titles are perfectly measured, so there will be no titles or undervalued- two, so that the net present value of the investment is zero. (Roberts 1987) This implies that if the market is efficient, time, money and effort spent on the analysis of the intrinsic value titles will be useless. If in an efficient market there be a disparity between the market price a title and its intrinsic value, this would be exploited by savvy speculators who act accordingly to take advantage of this "temporary inefficiency." (Petri 2004)

For example, the title was underrated these speculators would acquire, in order to get a quick capital gain, which would create a pressure of demand on the title would push the price up to place it in its intrinsic value. If, on the Otherwise, the title was overrated sell those same speculators with that its price would fall, due to supply pressure, reaching its theoretical value. In summary, only the most savvy will draw a benefit from the inefficiencies time (the more speculators of this type has lower profit), the rest participants believe really be in an efficient market. (Petri 2004)

Obviously, there is great difficulty in estimating the theoretical price of a title either, since both the expectations of future dividends, as the economic planning horizon, or predictions about the evolution of the framework socioeconomic status, are different for each particular investor. Now, if the market is efficient, multiple estimates of the value of a financial asset should range from randomly around its true intrinsic value. (Novshek 1987)

Therefore, all investors have the same chance of winning or losing (the higher returns than some investors can get the rest are due to chance). This type of market should necessarily be competitive, since it is the only way that all the information substantial value of the securities is immediately reflected in prices. (Pagano, M. And A. Roell 1996)

The effect oblivion and the liquidity effect

Another interpretation of size effect in January is that provided by Lee (1998). Assume that smaller firms tend to be neglected by large institutional traders because the information on such companies is less available. Indeed, this deficiency in the information makes it risky to invest in those companies which require a higher expected return.

Liu, Strong and Xu (1999) measured the deficiency of information using the coefficient of variation of the benefits expected by analysts. The correlation coefficient between the coefficient of variation and the total yield of 0.676 was quite high and statistically significant. McNulty (1967) argue that investors demand a higher rate of return by investing in less liquid securities that carry higher transaction costs.

Indeed, spreads between buying and selling prices of such securities may be worth more than 5% of their market. In any case, this theory does not explain why the abnormal returns of small firms are concentrated in the month of January. While it is true that the transaction costs on these securities will offset any chance of abnormal gain.

Market value of shares "versus" book value

Besides the effect size shown by Banz (1981) is interesting to note the positive relationship between average performance and financial leverage reported by Bhandari (1988), as well as the relationship between performances significantly. Also the title and the ratio book value and market capitalization in the study said Chan, Hamao and Lakonishok (1991).

The study of Basu (1983) shows that the inverse of PER helps explain the expected return, while Ball (1978) believes that the inverse of the PER is to replace in any way at all unknown factors upon which the expected return of securities. Fama and French (1992) analyzed the above effects together and conclude that the sseta, company size, leverage, the ratio of book value and market value of the shares and the benefit-cost ratio can be replaced at in capturing the variations in the average yields of equity shares by two easily determined variables such as size and value for equity-market capitalization. (Naidu, G.N. And M. Rozeff 1994)

The results are therefore unfavorable to the validity of the CAPM or, if you will, to sseta ability to determine the average yield. However, as indicated by these two authors, assuming that the behavior of returns is properly explained by the relationship book value and market capitalization size, as is the case in their study, the current issue of discussion, we focus in determining the economic explanation of the role of these variables and what kind of risk they represent. One possible explanation is that these two variables contained a risk factor in returns related to the prospects of the relative benefits. For example, as the authors, companies with lower market price and, therefore, with a book value ratio-cap value, tend to earn higher returns (because they are penalized with higher costs of capital) companies that have a lower ratio, i.e. A higher market price. (Moskowitz, T.J. And M. Grinblatt 1999)

Conclusions

Those investors who believe that financial markets are efficient are devoted to a passive management of their portfolios as they think that any analysis of past and current information is a waste of time. However, there are enough anomalies in these markets to justify the search for undervalued financial assets. While it is true that any investment strategy that initially starts beating the market will be quickly offset by other investors due to strong competition in the market. Only the achievement of a better in-formation that the other competitors (including insider trading) may give a slight superiority in the management of portfolios performed by professionals. (Nagel 2001)