Market efficiency refers to how well security prices reflect available information, ensuring that prices accurately represent the true value and future cash flows of securities.

 

Ideal State: In an ideal scenario, security prices would incorporate all information about cash flows, risks, and timing, adjusting promptly as new information emerges.

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Efficient Market Hypothesis (EMH): EMH is a fundamental theory that underpins market efficiency, focusing on how well markets reflect information in security prices.

 

Importance of Market Efficiency Theory

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The efficient market hypothesis (EMH) is significant because it implies that free markets can optimally allocate and distribute products, services, capital, or labor (depending on the market's purpose), without the need for central planning, oversight, or government intervention. According to the EMH, prices reflect all available information and serve as a balance between supply (sellers/producers) and demand. One significant implication is that it is impossible to "beat the market" because there are no anomalous profit possibilities in an efficient market.

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Forms of Market Efficiency

 

1. Strong-Form Efficiency - According to the strong form of the efficient market hypothesis, all information—both public and private—is fully accounted for in current stock prices, and no type of information can provide an investor with a market advantage. Advocates for this level of the theory argue that investors cannot earn returns on investments that exceed regular market returns, regardless of the information obtained or the study undertaken.

 

Implication: Investors cannot earn returns greater than market averages based on private information.

 

Reality: More of an ideal state than a practical reality.

 

2. Semistrong-Form Efficiency - The semi-strong form efficiency hypothesis holds that because all publicly available information is used to calculate a stock's current price, investors cannot employ technical or fundamental analysis to increase their market returns.

 

Those who believe in this form of the idea believe that only information that is not widely available to the public can assist investors increase their returns to levels higher than the general market.

 

Example: Investors with private information could gain an edge through analysis or discussions.

 

Applicability: Represents how most large stock markets operate.

 

3. Weak-Form Efficiency - The weak form implies that today's stock prices reflect all past values and that no form of technical analysis can successfully assist investors in making trading decisions.

 

Advocates of the weak form efficiency hypothesis claim that by using fundamental analysis, investors can identify cheap and overvalued securities, as well as examine firms' financial statements to boost their chances of earning higher-than-market-average profits.

 

Limitation: Investors cannot earn returns greater than market averages based on historical price patterns.

 

Opportunity: Returns can be earned based on public or private information, not historical trends.

 

MULTIPLE CHOICE

 

1. The best characterization of the strong form of the efficient market hypothesis (EMH) with respect to the information set is that it encompasses ______.

A. neither the weak-form nor the semi-strong-form hypothesis

B. the semi-strong-form but not the weak-form hypothesis

C. both the weak-form and semi-strong-form hypotheses

 

2. Strong-form efficient markets theory proclaims that:

A) one can chart historical stock prices to predict future stock prices such that you can identify mispriced stocks and routinely outperform the market

B) one can exploit publicly available news or financial statement information to routinely outperform the market

C) current prices reflect the price and volume history of the stock, all publicly available information, and all private information

D) current prices reflect the price and volume history of the stock, all publicly available information, but no private information

 

3. In ________, current prices reflect the price history and trading volume of the stock. It is of no use to chart historical stock prices to predict future stock prices such that you can identify mispriced stocks and routinely outperform the market.

A) weak-form efficient markets

B) strong-form efficient markets

C) semi-strong-form efficient markets

D) operational efficient markets

 

4. The Efficient Market Hypothesis (EMH) is often criticized for its:

A) assumption that all investors have access to the same information

B) failure to account for the impact of emotions on market behavior

C) inability to explain the persistence of certain market trends

D) reliance on the concept of "efficient" markets, which may not always be the cas

 

5. A study that finds a significant correlation between past stock prices and future stock prices would:

A) support the Efficient Market Hypothesis (EMH) by showing that prices reflect all available information

B) challenge the EMH by suggesting that historical prices can be used to predict future prices

C) be irrelevant to the EMH, as it only concerns publicly available information

D) be a result of data mining, and therefore not reliable.

 

ESSAY

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1. Please briefly explain the consequences of an inefficient market.

2. Please briefly explain what Efficient Market Hypothesis refers to. In your answer, please include clarifications on the concepts of intrinsic value and price.

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ANSWER KEY

 

MULTIPLE CHOICE

 

1. C - It relates to both.

2. C. - current prices reflect the price and volume history of the stock, all publicly available information, and all private information

3. A - weak-form efficient markets

4. C -  inability to explain the persistence of certain market trends.

5. B - challenge the EMH by suggesting that historical prices can be used to predict future prices.

 

ESSAY

 

1. In an inefficient market, stock prices do not fully reflect all available information. This means that it may be possible to identify mispriced stocks and earn abnormal returns through active investment strategies, such as technical analysis or fundamental analysis. However, the ability to consistently outperform the market in an inefficient market is debated, as the market may eventually correct any mispricing

2. The Efficient Market Hypothesis (EMH) states that current stock prices fully reflect all available information, and that it is impossible to consistently outperform the market through stock selection or market timing. The concept of intrinsic value refers to the true underlying value of a stock, which may differ from its current market price. In an efficient market, the market price should equal the intrinsic value, as all relevant information is already reflected in the price

 

REFERENCES:
 

Team, I. (2022, April 2). Market efficiency explained: Differing opinions and examples. Investopedia. https://www.investopedia.com/terms/m/marketefficiency.asp

 

Panigrahi, A. (2008, October 31). Efficient Market Hypothesis and Indian Stock Market: A Critical assessment. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3471795