Analysis of the Efficient Market Hypothesis

The study of “efficient market hypothesis” is originate from Louis Bachelier (1900), he studied the “Brownian motion” and the randomness of the stock price change from the perspective of random process and he found that discounted value reflected in market prices that no matter in the past, present or in the future (Lim & Brooks, 2009). With the use of computer, Kendall (1953) finds that the randomness of stock price changes by the commodity prices and stock prices in Britain and the United States (Lim & Brooks, 2009). Later, Robert (1959) proves that there is no difference between a sequence from the random sequence and the share price of the United States (Lim & Brooks, 2009).

In 1964, Osborne puts forward the “random walk theory”, he believes that the change of stock price is similar to the molecular chemistry “Brownian motion” which means that the movement of the particles that suspended in a liquid or gas is continual and chaotic, and that means the change of stock price is unpredictable (Lim & Brooks, 2009). In 1970, Eugene Fama thinks that there is no “memory” of yield sequence of the stock price in statistics and inventors cannot predict its future direction based on the historical prices then Fama presents the efficient market hypothesis in 1970 (Lim & Brooks, 2009). The definition of the efficient market is that if the prices fully reflect all available information in a securities market that is called the economic market (Dimson & Mussavian, 1998).

Refers to the efficient market hypothesis theory, the security price can reflect all relevant security information sensitively, timely and accurately (Dimson & Mussavian, 1998). moreover for investors the securities information which has reflected in the stock prices is not available for their research which is in order to get more profit and this means that investors cannot get any information resources or analyze these information to make trading decisions to get extra benefits (Dimson & Mussavian, 1998). However, the efficient market theory is still questioned by a variety of new theories and the discussion about the validity of the capital market and the rationality of the investment decision will be more intense (Chordia et al, 2008).

This article is mainly discussing the concept of market efficiency and empirical approaches to test for it. In addition to analyze the strength and the weakness of the efficient market theory. This article is divided into four parts. The first part is illustrating the concept of the efficient market hypothesis. Then it will discuss three forms of market efficiency and test them. The third separation is analyzing meanings and limitations of the efficient market hypothesis theory. Finally, it will conclude the principal viewpoints and proposes some recommendations.

EFFICIENT MARKET
There are two kinds of definition of the economic market. One is the internally efficient markets that also called operationally efficient markets which is mainly measure the cost of trading when investors buy and sell securities such as the procedure fee from securities firm, the spread between commission and stock jobbery and so on (Jordan, 1983). The other is the externally efficient market that also called pricing efficient market which discusses whether the price of securities rapidly reflect all information which related to the price (Malkiel, 2003). These information includes all publicity available information about companies, industry, domestic and the world economy in addition include some internal private nonpublic information from individuals and groups (Laffont & Maskin, 1990).

There are three conditions to become an efficient capital market. Firstly, inventors can gain higher remuneration by using the existing information (Jordan, 1983). Second, the response between the securities market and new market information is rapidly and accurately that means stock prices can fully reflect all information (Jordan, 1983). Third, market competition makes the stock price change from the old equilibrium transition to the new equilibrium and it is independent between new information and corresponding price change (Jordan, 1983).

There are three points of the competent market hypothesis. First point is that every man is a rational economic man in the market and each stock represent the companies are strictly monitoring by these rational men (Laffont & Maskin, 1990). In addition, these rational men are in the basic analyze in everyday to assess the companies’ stock price which are based on the profitability of the companies’ future besides they need to convent the future value of present value and balance the benefits and risks carefully (Malkiel, 2003). Secondly, the stock price reflects the balance of the rational men of supply and demand which means that people who want to buy is equal to people who want to sell (Laffont & Maskin, 1990).

In other words, people who think the stock price is overvalued is equal to people who think the price is undervalued and if someone found these two are unequal that means there is the possible of arbitrage they will try to make them equal by buying or selling stocks (Malkiel, 2003). Final point is that stock prices can fully reflect all available information about the asset that called “effective information” (Malkiel, 2003). The price of the stock will change accordingly when the information changes that is to say the price of the stock began to move while good news or bad news has just come out and when the information is not secret, the stock prices have been rising or falling to the appropriate price (Lee et al, 2010). The efficient market hypothesis theory illustrates that there is no windfall in a routine efficient market (Timmermann & Granger, 2004).

THE TYPE OF EFFICIENT MARKET
According to Fama (1970), the definition of an efficient market is that the market is efficient when the stock prices can fully reflect the available information on the market (Dimson & Mussavian, 1998). In addition, the efficient market hypothesis separated into three types which are weak-form efficient market, semi-strong-form efficient market and strong-form efficient market (Malkiel, 2003).

The first type is weak-form efficient market that thinks price has fully reflected all the history of security price information in the case of the weak type of efficient market, such as stock price, trading volume, oversell amount, financing amount and so on (Malkiel, 2003). Similarity, Laffont & Maskin (1990) state that weak-form efficient market means any inventors cannot gain excess returns by using past information when the past securities information fully reflected in the current price. There is an inference of this type. Laffont & Maskin (1990) prove that the technical analysis of stock price will be out of action if the weak-form efficient market establish.

There are three ways to test the weak efficient market (Timmemann & Granger, 2004). First one is random walk test that means the fluctuation of securities price is random and unpredictable and adopting the correlation coefficient check and run a test to examine whether the price of stock or return series is a random walk process (Timmermann & Granger, 2004). The correlation coefficient check is a common test method of econometrics which can estimate the correlation between the sample data by means of testing the correlation coefficient between the random variable and lagged value in the sample data (Malkiel, 2003). Moreover, Andersen (1983) states that if the correlation coefficient between a random variable and the lagged value is smaller that means the weak effectiveness of the securities market is stronger.

The run test can measure whether there is the correlation between the time sequences by investigating the rule of time series of plus or minus (Malkiel, 2003). In this way, Fama (1965) examines the symbols and change range of stock price change from dozen listed companies and obtain a conclusion that market accord with weak efficient, however Osborne (1966) finds that both the change of stock price deviates from random walk thus his conclusion do not support the weak type of efficient market (Laffont & Maskin, 1990). Additional method is the filtering test which is test the profitability of trading strategy (Malkiel, 2003). Third one is the kinetic energy test that mainly aim at some anomalies in the market, for example a recent good stock may still be good in the short term that means there is a strong correlation between the yield of the stock meanwhile inventors can construct some profitable investment strategy based on this correlation (Malkiel, 2003).

The second type is semi-strong-form efficient market that is develop on a basis of weak-form efficient market and it means that all public available information about the securities prices reflected in current prices not only historical information but also including all public available information (Malkiel, 2003). Meanwhile, Timmermann & Granger (2004) prove that in this type, the basic analysis method that based on publicly available information is invalid because of fundamental analysis of the stock price is to analyze public information, such as political information, macroeconomic information, analysis if the relevant securities companies’ operating situation and so on. There is an inference of this type. Timmermann & Granger (2004) maintain that the technical analysis and the fundamental analysis are lost function in the semi-strong-form efficient market and inventors may gain excess profits rely on the inside information.

The way to test the semi-strong-form efficient market is the event test (Mayer-Sommer, 1979). The event inspection is mainly test the effectiveness of semi-strong-form market by estimating the reaction speed of the stock prices to new information in the market (Malkiel, 2003). Malkiel (2003) stresses that pay attention to the following aspects of the impact of stock prices, first is the issue of stock split, allotment of shares and divided can influence the stock prices. Second are the earnings information released can affect the stock prices (Malkiel, 2003). Third is the recommendations and suggestions from securities analyst can influence the stock prices (Malkiel, 2003).

The third type is strong-form efficient market that is the highest level of efficient markets and the prices of securities reflected all information about the securities which include public information and inside information in this market (Timmermann & Granger, 2004). Moreover, Malkiel (2003) states that if some inventors can get returns using inside information then the information will reveal and reflect on the prices of securities. Besides the reaction speed of the information is faster shows the degree of the market is higher. There is an inference of this type. Timmermann & Granger (2004) state that there is no method to help inventors get excess profits even if knowing inside information.

The way to test the strong-form efficient market is mainly estimated whether inventors who master the inside information can get excess profits (Timmermann & Granger, 2004). In addition, Malkiel (2003) proves that the significant method to determine whether the market is reached strong type is by analysing insider trading information and the investment performance of fund managers. Jaffe (1974) finds that insiders could obtain excess profits by inside information meanwhile the prices of stock cannot fully reflect the insider information because of the reaction of other inventors is not fast enough that means the market is not the strong type (Malkiel, 2003). Some scholars determined the strong-form efficient market is depending on empirical research of fund managers’ performance Investment (Jordan, 1983). However, Timmermann & Granger (2004) think that research cannot rely on the managers’ performance investments to determine whether the market reached a strong level because of these managers can use their knowledge to get a good chance to obtain profits.

THE SIGNIFICANCE OF THE THEORY
There are two essential significances, one is theoretical significance and the other is practical meaning. On one hand, the economical market hypothesis is conductive to improve the effectiveness of the securities market theoretically (Laffer & Ranson, 1978). In addition, Timmermann & Granger (2004) note that the essential issues to improve the effectiveness of the securities market is to solve the problems in securities price forming process, for example problem in information disclosure, information transmission, information interpretation and information feedback, moreover one of the most effective measure is to built a system of mandatory information disclosure of listed companies. Similarity, Lee et al (2010) stress that the system of mandatory information disclosure is the foundation of establishing an effective capital market and it is the start point to improve the efficiency of the capital market.

On the other hand, there are three points of functional significance of the efficient market hypothesis (Laffer & Ranson, 1978). First point is the role of technical analysis in an efficient market. Mayer-Sommer (1979) presents that if the market is not a weak-form efficient market which means the current price cannot fully reflect the historical price information. In addition, in this situation inventors can profit in the transaction by using the technical analysis of the past information to obtain the change tendency of the future price (Mayer-Sommer, 1979). On the contrary, if the market is a weak-form efficient market that means price changes are unconcerned with the historical price information and the technical analysis will fail in this situation (Jordan, 1983).

Second point is the function of basic analysis in efficient market, Timmermann & Granger (2004) stress that if the market is not a semi-strong-form efficient market that means public information is incompletely reflect the current price and inventors can increase income by analysis public information to estimate the future price in this situation. However, the basic analysis of shared information is useless to estimate future price in a semi-strong-form efficient market (Lee et al, 2010). Third point is the role of equity portfolio management in efficient market, Jordan (1983) states that any new information are quickly reflected in a strong-form efficient market and in this situation the managers of equity portfolio management have to take negative attitude to get the average yield. Nevertheless, if the market is not a strong-form efficient market, the managers of equity portfolio organizations will be positive to gain excess profits (Laffer & Ranson, 1978).

LIMITATIONS AND CHALLENGES
Although the competent market hypothesis has more supporters, the limitations of this theory are obvious. There are three aspects of the limitations. Firstly, for inventors, the efficient market hypothesis states that inventors are rational but inventors are limited rational in the real market (Malkiel, 2003). At the same, Andersen (1983) believes that inventors have different investment preferences and they have different expectations for market behavior thus inventors cannot be regarded as rational. Otherwise, there might be some differences between various inventors on the aspect of collecting and analyzing information and the reaction of new information to different inventors might be different (Malkiel, 2003). Secondly, for the market, Timmermann & Granger (2004) maintain that there is no frictionless and complete market in the real world, for example the efficient market hypothesis has no regard for market liquidity and this theory cannot explain why the stock market crash and boom happen.

In addition, Lee et al (2010) believe that the efficient market does not obey the random walk that means the deviation of the random walk cannot represent the market is invalid. Thirdly, for information, Andersen (1983) thinks that the definition of information is not clear and the analysis of information is not accurate in this theory. The efficient market hypothesis assumes that there is no cost to obtain any information, but there are costs to collect information especially private information in reality that may reduce the benefits from the information (Malkiel, 2003). Moreover, Malkiel (2003) states that there are many false information and some information about market expectations from professional inventors in the genuine market and these information will influence the efficiency of the market.

There are some challenges for the efficient market hypothesis theory. On the one hand, the chaotic economic challenges to the efficient market hypothesis in theory (Lee et al, 2010). Chaotic economics provide that the relationship between information and price is not a linear relation but a complicated nonlinear relation and this theory is confirmed by “Black Monday” that happened in the U.S. stock market in October 1987 (Lee et al, 2010). On the other hand, the experiential results challenge to the efficient market hypothesis theory (Andersen, 1983). With the development of theoretical research, there are many inconsistencies between the empirical and theory and there are many abnormal phenomenon, such as the equity premium puzzle, January effect, Herd behavior and so on (Andersen, 1983).

CONCLUSION
In conclusion, this essay mainly discussing the concept of market efficiency and empirical approaches to test for it, in addition to analyse the significance and the limitations of the efficient market theory. The efficient market hypothesis theory is a model of perfect competition market which is based on the complete rationality and this theory is the foundation of modern portfolio theory meanwhile it occupies a significant position in the capital market theory (Dimson & Mussavian, 1998). The core of this theory is that security prices are always able to reflect all relevant information in the efficient market (Timmermann & Granger, 2004). The emergence of this theory, also masks the official formation of modern portfolio theory system (Dimson & Mussavian, 1998). In addition, Laffont & Maskin (1990) prove that scholars are widely used this theory in the empirical test and produces a lot of valuable research consequences.

However, the efficient market hypothesis theory is an ideal condition of the financial market and there are lots of differences between real condition and assumptions (Jordan, 1983). With the development of theoretical research, there are various defects about this theory, for example, the unaccountable economic phenomenon has been increased (Timmermann & Granger, 2004). Currently, there are various theories make breakthroughs on economic assumptions, such as the behavioral finance theory and adaptive rational hypothesis (Lim & Brooks, 2009). Therefore, a good financial theory is not only conformed to the characteristics of the market but also is amenable to testing. As a study of prior time, there are some weaknesses in this article. It is important to improve the coverage of knowledge and extend the range of references. Meanwhile, this article should increase concrete examples of these financial phenomenons.

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