Market Efficiency Theory - Essay
“Every event, no matter how remote or long ago, echoes across all other events - Market Efficiency Theory - Essay introduction. ” (Mandelbrot, 2004) Modern financial implications perceive every action/reaction on markets as a result/cause of more complex, mutually dependent events. Studies of these relations began with the simplest ‘random walk’ hypothesis stating that price reactions are unforecastable. It was supported by ‘martingale’ stochastic process. Theoretically it is not possible to fully exist, as there would be no place for speculation and participants would become more like gamblers than stock traders.
However it laid foundations to further studies. Use of more sophisticated technology enabled to determine non-random movements and anomalies in asset prices. Suspicious fluctuations, after investigation, brought up conclusions that were not based on probability but mainly on informational influence. The extreme hypothesis represented an abstract situation, where all information were reliable and truly reflect value of securities. Overvalued or undervalued assets would not exist. Efficient Market Hypothesis was affecting economical environment for last four decades.
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Financial practice along with further academic examinations have strongly relied on it outcomes (Roll, 1997). Despite inconsistencies, like behavioural forces, it was not rejected. Some financers has started a debate about deceptive influence of EMH on traders. They are claiming that lack of risk amendments in the theory caused participants to have “chronic underestimation of the dangers of asset bubbles breaking” (Nocera, 2009) The purpose of this paper is to analyse impact of Efficient Market Hypothesis on Modern Financial Theory principles and practice and as the essence to highlight relativeness of this dependence.
It is going to point major financial tools based on EMH and subsequently present the influence from investors’ and companies’ point of view. Highlighting the importance of markets being efficient is possible by mentioning the example of Capital Asset Pricing Model. In inefficient market the credibility of risk-return indications of CAPM is none. In such situation creating a diversified portfolio is pointless because determining future returns or overvaluation cannot be concluded from any fundamental information available on the market. Lumby & Jones, 2003). Tracking this pattern, the discounted cash flow analysis is impossible to apply as Net Present Value discount rates would be unreliable. Therefore financial managers could not predict possible returns on similar investments. Long term investment planning consist in NPV however NPV is enabled only under assumption of markets being efficient. Another point which supports EMH ,in view of financial practice, is importance between communicating information to market and receiving a correct security evaluation from it. Lumby & Jones 2003) In this case of inefficiency, disclosure of significant information could abstractly have less powerful impact on share price than completely not associated announcement . Further influence of EMH on financial practice seems to be active in attitude of investors towards diversified portfolios. As theory implicate “public information cannot be used to earn abnormal returns” (Arnold, 2009) thus traders are becoming more sceptical about outcomes of fundamental analysis.
The most reasonable action is to create well-matched selection of securities that would rule out analysis and transaction costs, making returns proportionally greater. The vast majority of investors were convinced by those trends and decided to allocate their capital in ‘index funds’. ”About 25 per cent of UK financial assets managed by professional investors (e. g. unit trusts) is in indexed funds. For the USA figure is 35 per cent” (Arnold, 2009).
The most surprising is the fact that their average return over perform short-term traders and those who chose thoroughly analysed set of shares. As a resultant of this trend it is noticed that the rest of investors tend to trade independently (without broker consultations). Strong form of efficiency is generally perceived as unlikely to exist thus participants acknowledge the power of information. Currently companies are pressured to disclose more accurate and up-to the-minute announcements which make markets more dynamic and flexible.
It is another highlight of EMH impact on current trading practices. Company’s approach to the market, relying on the EMH basis, concern slightly different matters. Belief in power of information has created adjusted manager’s approach to numerous situations. Creative accounting is the best example of huge effort of directors to present the best possible current business condition (Atrill & McLaney, 2008). It is followed by disturbing concentration on short term appearance that often cause negative results for shareholders in a long run.
Decision making process on particular investment used to rely on NPV mentioned before. Now even really good provident plan can be rejected because of low accounting rate of return (ARR) that would question company’s performance. These operations are aiming to deceive participants and create ‘impression of improvement’ of financial condition. In highly efficient stock exchanges( like NYSE or LSE) those procedures should not trick whole market, and usually do not(Reilly, 2002).
However example of Mc Donald’s creative accounting is one of numerous exemptions where market fail to acknowledge the ‘real’ economical significance of accounting change. It was not corrected until the publication of an article pointing those malfunctions (Lumby & Jones, 2003). Another hassle for managers is whether or not to issue new stock. The major study of EMH implemented by FFJR (Fama, Fisher, Jensen, Roll) indicated 3% fall after announcement of new public stock. It states that when directors assume that company is overvalued they tend to issue stock (Ball, 2003).
However currently managers are more likely to undertake this action when they are convinced that shares are “underpriced because the market is ‘low’ “(Arnold, 2009). That is followed by another dilemma, should they wait for better quotations to boost the increase or not. According to core thesis of EMH, market should already have priced them correctly. These doubts clearly prove that semi strong level of market efficiency is favoured by corporate world. Despite many implications of EMH in today’s financial practice there should be no speculation about markets being perfectly efficient.
All participants witness rapid anticipation of new announcements. However not all of them are evaluated properly and therefore create feeling of deception. In such wide network of organisations where money play main role, many people make exceptional effort to ‘beat’ stock market. Companies tend to disclose unfavourable announcements in the most convenient moments, ‘insiders’ make use of confidential information before it is going to come to light. Many unethical or even illegal actions are undertaken by participants for personal gains.
It is a clear evident that markets are not fully efficient however further governmental regulations tend to stamp out those behaviours and it might raise an assumption that this environment is moving towards higher levels of efficiency. That would obviously result with extinction of many specialist of fundamental or technical analysis due to ‘fair game’ that would make abnormal profits impossible (Lumby & Jones, 2003). Furthermore it would be supported by relative influence of ‘random walk’ as a part of EMH. The most accurate view, applicable to current markets, is the relative fficiency concept, which determines the level of efficiency of a particular market or segment (Lo, 1997). It supports initial thesis stating that relevance of EMH influence on modern financial perception is dependent on particular factors. In other words the amount of overreactions, underreactionsand anomalies caused by behavioural forces is a variable. Quite similarly as originally mentioned phrase “Every event, no matter how remote or long ago, echoes across all other events. ” (Mandelbrot, 2004) References: Mandelbrot, B. & Hudson, L. , 2004.
Misbehaviour of markets. Basic Books, pp. 229. Lo, A. , 1997. Market efficiency: stock market behaviour in theory and practice, Volume 1. Edward Elgar Publishing, pp. X-XI. Nocera, J. , 2009. Poking Holes in a Theory on Markets. New York Times, 5 June. Lumby, S. & Jones, C. , 2003. Corporate finance: theory & practice. Cengage Learning EMEA, pp. 356-357. Arnold, G. , 2008. Corporate financial management. Pearson Education, pp. 602-603. Atrill, P. & McLaney, E. 2008. Accounting and finance for non-specialists. 6th ed. Pearson Education, pp. 44-146. Ball, R. 2003. The Theory of Stock Market Efficiency: Accomplishments and Limitations. Wiley-Blackwell. 4th ed. pp. 11-15 Bibliography Mandelbrot, B. & Hudson, L. , 2004. Misbehaviour of markets. Basic Books, pp. 11-103. Lo, A. , 1997. Market efficiency: stock market behaviour in theory and practice, Volume 1. Edward Elgar Publishing, pp. IX-XX Nocera, J. , 2009. Poking Holes in a Theory on Markets. New York Times, 5 June. Lumby, S. & Jones, C. , 2003. Corporate finance: theory & practice. Cengage Learning EMEA, pp. 55-377. Arnold, G. , 2008. Corporate financial management. Pearson Education, pp. 565-614. Atrill, P. & McLaney, E. 2008. Accounting and finance for non-specialists. 6th ed. Pearson Education, pp. 129-134 Pike, R. & Neale, B. 2006. Corporate finance and investment: decisions & strategies. 5th ed. Pearson Education Baskin, J. & Miranti, P. 1999. A history of corporate finance. Cambridge University Press, pp. 11-20. Stern, J. & Chew, D. 2003. The revolution in corporate finance. 4th ed. Wiley-Blackwell, Ch. 2