Efficient Market Theory

Basic Concepts
1.Market efficiency : the accuracy & quickness
in which the market translates the
expectation into the prices are termed as
market efficiency. There are two types of
market efficiency :
ii.Operational efficiency
iii.Information efficiency
2. Liquidity traders : these traders
investments & resale of shares depend upon
their individual fortune. They do not
investigate before they invest
3. Information Traders: they analyze before
adopting any buy or sell strategy. They
estimate intrinsic value of share.
Efficient Market
According E.F. Fama “Efficient market is
defined as the market where there are
large number of rational profit-maximisers,
actively competing with each other to
predict even the market value of individual
securities and where current information is
almost freely available to all participants.”
Features of Efficient Market
All instruments are correctly priced as all
available information is perfectly
understood and absorbed by all the
investors.
No excess profits are possible.
In a perfectly efficient market analysts
immediately compete away any chance of
earning abnormal profits.
The forces of demand and supply move
freely and in an independent and random
manner.

Explanation for the efficiency
of the markets
The equilibrium price of the security is
determined by demand and supply forces
based in available information. This
equilibrium price will immediately change
as fresh information becomes available.

 Assumptions

Information must be free and quick to flow.

There are no transaction costs and bottlenecks.
Taxes do not impact investment policy.
Every investor can borrow or lend at the same
rate.
Investors behave rationally.
Market prices are efficient and absorb the
market information quickly and efficiently.
Future price changes will be due to new
information not available earlier.


FORMS OF THE EFFICIENT
MARKET HYPOTHESIS (EMH)

Efficient market hypothesis can be divided into

three categories:
1.The weak form
2.The semi strong form, and
3.The strong form.
1.Weak form of EMH : according to it , current
prices reflect all information which is
already contained in the past. The weak
form of theory is just opposite of
technical analysis. In the weak form of
efficiency market, the past prices do not
provide help in giving any information
about the future prices. The short term
trader adopt ‘buy & hold’ strategy.
2.Semi Strong Form : The semi strong
form of the efficient market
hypothesis says that current prices of
stocks reflect all publicly available
information. In effect, the semi strong
form of the efficient market
hypothesis maintains that as soon as
information becomes publicly
available, it is absorbed and reflected
in stock prices. Even if this adjustment
 3. Strong Form of EMH: Strong form of the
efficient market hypothesis maintains that
security prices fully reflect all information,
including both public and private information.
Specifically, no information that is available be
it public or insider can be used to consistently
earn superior investment returns. This implies
that not even security analysts and portfolio
managers who have access to information
more quickly than the general investing public
is able to use this information earn superior
returns.
 Empirical Tests of weak
form
1.Empirical test on weak form :
ii.Simulation Tests
iii.Serial correlation tests
iv. Run Tests
v. Filter Tests
vi. Distribution Patterns

2. Empirical Tests of Semi-Strong form :
i. Market Reaction test.
ii.Announcement Test
3. Empirical test of the strong from :

i. Mutual fund performance


Random Walk -Conclusions
It suggests that the successive price
changes are independent. & these
successive price changes are randomly
distributed. This model argues that all
publicly available information is fully
reflected on the stock prices & further the
stock prices instantaneously adjust
themselves to the available information.
 technical and fundamental
analysis

Random walk and technical analysis :

 The random walk theory is inconsistent with
technical analysis.
 Random walk states that successive price
changes are independent, while the technical
analysts claim that the historical price behavior
of the stock will repeat itself into the future and
that by studying this past behavior the chartist
can predict the future.



Random walk and Fundamental Analysis
 The random walk hypothesis is entirely
consistent with an upward or downward
movement in price.
 The hypothesis supports fundamental
analysis and certainly does not attack it.
 Random walk implies that short run price
changes are random about the intrinsic value of
the security and are independent of each other.
Industry Life Cycle
SALES

Introducti Expansion Maturity Stabilizat

on ion or
Decline
 SWOT Analysis
Strength
Weaknesses
Opportunities
Threat

Competitive Structure of
Industry
1)Rivalry among existing firms
2)Threat of new entrance
3)Threat of substitutes
4)Bargaining power of suppliers
5)Bargaining power of buyers