Propiedad y Derechos sobre el agua en Ecuador

• The theory behind share price movements can be explained by the three forms of the efficient market hypothesis:

– Weak form efficiency implies that prices reflect all relevant information about past price movements and their implications.

– Semi-strong form efficiency implies that prices reflect past price movements and publicly available knowledge.

– Strong form efficiency implies that prices reflect past price movements, publicly available knowledge and inside knowledge.

Definition

The efficient market hypothesis (EMH) is the hypothesis that the stock market reacts immediately to all the information that is available. Therefore, a long-term investor cannot obtain higher than average returns from a well-diversified share portfolio.

1.1 The definition of efficiency

Different types of efficiency can be distinguished in the context of the operation of financial markets: (a) Allocative efficiency

If financial markets allow funds to be directed towards companies which make the most productive use of them, then there is allocative efficiency in these markets.

(b) Operational efficiency

Transaction costs are incurred by participants in financial markets, for example commissions on share transactions, margins between interest rates for lending and for borrowing, and loan

arrangement fees. Financial markets have operational efficiency if transaction costs are kept as low as possible. Transaction costs are kept low where there is open competition between brokers and other market participants.

(c) Information processing efficiency

The information processing efficiency of a stock market means the ability of a stock market to price stocks and shares fairly and quickly. An efficient market in this sense is one in which the market prices of all securities reflect all the available information.

1.2 Features of efficient markets

It has been argued that the stock markets are efficient capital markets, that is, markets in which:

(a) The prices of securities bought and sold reflect all the relevant information which is available to the buyers and sellers: in other words, share prices change quickly to reflect all new information about future prospects.

(b) No individual dominates the market.

(c) Transaction costs of buying and selling are not so high as to discourage trading significantly. (d) Investors are rational.

1.3 Impact of efficiency on share prices

If the stock market is efficient, share prices should vary in a rational way:

(a) If a company makes an investment with a positive net present value (NPV), shareholders will get to know about it and the market price of its shares will rise in anticipation of future dividend increases.

(b) If a company makes a bad investment shareholders will find out and so the price of its shares will fall.

(c) If interest rates rise, shareholders will want a higher return from their investments, so market prices will fall.

1.4 Varying degrees of efficiency

There are three degrees or 'forms' of efficiency: weak form, semi-strong form and strong form.

1.4.1 Weak form efficiency

Under the weak form hypothesis of market efficiency, share prices reflect all available information about

past changes in the share price.

Since new information arrives unexpectedly, changes in share prices should occur in a random fashion. If it is correct, then using technical analysis to study past share price movements will not give anyone an advantage, because the information they use to predict share prices is already reflected in the share price.

1.4.2 Semi-strong form efficiency

If a stock market displays semi-strong efficiency, current share prices reflect:

• All relevant information about past price movements and their implications, and • All knowledge which is available publicly.

This means that individuals cannot 'beat the market' by reading the newspapers or annual reports, since the information contained in these will be reflected in the share price.

Tests to prove semi-strong efficiency have concentrated on the speed and accuracy of stock market response to information and on the ability of the market to anticipate share price changes before new information is formally announced. For example, if two companies plan a merger, share prices of the two companies will inevitably change once the merger plans are formally announced. The market would show semi-strong form efficiency, however, if it were able to anticipate such an announcement so that share prices of the companies concerned would change in advance of the merger plans being confirmed. Research in both the UK and the US has suggested that market prices anticipate mergers several months before they are formally announced, and the conclusion drawn is that the stock markets in these countries

do exhibit semi-strong form efficiency.

1.4.3 Strong form efficiency

If a stock market displays a strong form of efficiency, share prices reflect all information whether publicly available or not:

• From past price changes.

• From public knowledge or anticipation.

• From specialists' or experts' insider knowledge (e.g. investment managers).

1.5 Implications of efficient market hypothesis for the financial

manager

If the market is strongly efficient, there is little point in financial managers trying strategies that will attempt to mislead the markets:

(a) There is no point for example in trying to identify a correct date when shares should be issued, since share prices will always reflect the true worth of the company.

(b) The market will identify any attempts to window dress the accounts and put an optimistic spin on the figures.

(c) The market will decide what level of return it requires for the risk involved in making an investment in the company. It is pointless for the company to try to change the market's view by issuing different types of capital instruments.

Similarly if the company is looking to expand, the directors will be wasting their time if they seek as

takeover targets companies whose shares are undervalued, since the market will fairly value all companies' shares.

Only if the market is semi-strongly efficient, and the financial managers possess inside information that would significantly alter the price of the company's shares if released to the market, could they perhaps gain an advantage. However, attempts to take account of this inside information may breach insider-dealing laws. The different characteristics of a semi-strong form and a strong form efficient market therefore affect the

timing of share price movements in cases where the relevant information becomes available to the market eventually. The difference between the two forms of market efficiency is concerned with when the share prices change, not by how much prices eventually change.

1.6 Criticisms of the efficient market hypothesis

The EMH has been the cornerstone of financial management and economic theories for more than 30 years. However, recent events such as the dot.com bubble and the current global financial crisis have brought forward criticisms of the EMH. The dot.com bubble is the term used to describe the sequence of events in the 1990s when newly formed businesses trading on the Internet were set up, expanded rapidly but then declined as rapidly. Their share prices increased far out of proportion to the actual value of the company concerned and many investors lost large sums of money when the bubble burst. It has been argued that as one of the assumptions of EMH theory is that investors are rational then the prices in the market will always be correct. However, arguments from the school of behavioural finance insist that investors are not always rational and therefore market prices are not always correct. This is particularly the case in scenarios such as the dot.com rise and collapse.

In more recent times the EMH has been attacked by critics who argue that belief in rational markets has had much to do with the current global financial crisis. The EMH states that prices cannot be wrong: if the price is wrong then market forces will act to seek to profit from the error and therefore correct it. This is perhaps its fatal flaw. As a further example, rating agencies in the US assumed that sub-prime mortgages would behave in a random fashion – there would never be large amounts of people defaulting at the same time! Some commentators have gone as far as to state that the global financial crisis was in fact caused by the EMH claiming that belief in the hypothesis led financial leaders to underestimate the dangers of the bursting of 'bubbles' of vastly over-inflated asset values.

Question 1: EMH

Briefly describe the three forms of capital market efficiency.

(The answer is at the end of the chapter)