18 November 2016

Efficient Market Hypothesis and its types

Efficient Market Hypothesis and its types

EMH (Efficient Market Hypothesis) elaborates that all relevant information is fully and immediately reflected in market price of a security where an investor will receive stable rate of return. In other words, an investor should not expect to earn an abnormal return (above the market return) through either technical analysis or fundamental analysis.
The efficient market hypothesis (EMH) implies that if new information is revealed about a firm it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement. In an efficient market no trader will be presented with an opportunity for making a return on a share (or other security) that is greater than a fair return for the riskiness associated with that share (or any other security). The absence of abnormal profit possibilities arises because current and past information is immediately reflected in current prices. It is only new information, which causes prices to change.

Note:  Stock market efficiency does not mean that investors have perfect powers of prediction; all it means is that the current level is an unbiased estimate of its true economic value based on the information revealed. In the major stock markets of the world prices are set by forces of supply and demand. There are hundreds of analysts and thousands of traders, each receiving new information on a company through electronic and paper media. The moment an unexpected, positive piece of information leaks out investors will act and prices will rise rapidly to a level that gives no opportunity to make further profit.

Types of Efficiency

There are Three types of Efficiency such as Operational efficiency, allocation efficiency and Pricing Efficiency. Do not confuse these with the levels of market efficiency such as Weak form, Semi-strong form and Strong form of market efficiencies. Lets discuss the types here

  1. Operational efficiency – refers to the cost to buyers and sellers of transactions in securities on the exchange. It is desirable that the market carries out its operations at as low a cost as possible. This may be promoted by creating as much competition between market makers and brokers as possible so that they earn only normal profits and not excessively high profits. It may also be enhanced by competition between exchanges for secondary-market transactions.
  2. Allocation efficiency – Our society has a scarcity of resources (that is, they are limited) and it is important that we find mechanisms, to allocate those resources to where they can be most productive. Those industrial and commercial firms with the greatest potential to use investment funds effectively need a method to channel funds their way. Stock markets help in the process of allocating society’s resources between competing real investments. For example, an efficient market provides vast funds for fast-growth sectors such as Information Technology, Automobiles and Banking industries (through IPO, Right issues and etc..,) whereas allocates only small amounts for slow-growth industries.
  3. Pricing efficiency – In a pricing efficient market the investor can expect to earn merely a risk-adjusted return from an investment as prices move instantaneously and in an unbiased manner to any news. It is pricing efficiency that is the focus of this section and the term efficient market hypothesis applies to this form of efficiency only.

Subscribe Sulthan Academy to receive updates. Leave your comments and queries in comment section below. Share with your friends.