effective MARKET HYPOTHESIS

Efficient Market Hypothesis

Efficient Market Hypothesis

Question # 1

Versions of effective Markets Hypothesis

The efficient markets hypothesis predicts that market prices should incorporate all available information at any point in time. There are, however, different kinds of information that influence security values. Consequently, financial researchers distinguish among versions of Efficient Markets Hypothesis, depending on what is meant by term all available information.

Weak Form Efficiency

The weak form of efficient markets hypothesis asserts that current price fully incorporates information contained in past history of prices only. That is, nobody can detect mis-priced securities and beat market by analyzing past prices. The weak form of hypothesis got its name for the reason - security prices are arguably most public as well as most easily available pieces of information. Thus, one should not be adept to earnings from using certain thing that everybody additional knows. On other hand, many financial analysts attempt to generate profits by studying exactly what this hypothesis asserts is of no value - past stock price series and trading volume data. This method is called mechanical analysis.

The empirical evidence for this forms of market efficiency, and therefore against value of technical analysis, is pretty strong and quite consistent. After taking into account transaction costs of analyzing and of trading securities it is very difficult to make money on publicly available information such as past sequence of stock prices.

The assertion behind semi-strong market efficiency is still that one should not be able to profit using something that everybody else knows (the information is public). Nevertheless, this assumption is far more powerful than that of weak-form efficiency. Semi strong efficiency of markets requires existence of market analysts who are not only financial economists able to comprehend implications of vast financial information, but also macroeconomists, experts adept at understanding processes in product and input markets. Arguably, acquisition of such abilities should take allotment of time and effort. In addition, public information may be relatively difficult to gather and costly to process. It may not be sufficient to gain information from, say, major newspapers and company-produced publications. One may have to follow wire reports, professional publications and databases, local papers, research journals etc. in order to gather all information necessary to effectively analyze securities.

Semi-strong Form Efficiency

The semi-strong-form of market efficiency hypothesis suggests that current price fully incorporates all publicly available information. Public information includes not only past prices, but also data reported in the company's financial statements (annual reports, income statements, filings for Security and Exchange Commission, etc.), earnings and dividend announcements, announced merger plans, financial situation of company's competitors, expectations regarding macroeconomic factors (such as inflation, unemployment), etc. In detail, public data does not even have to be of the firmly financial nature. For example, for analysis of pharmaceutical companies, relevant public information may include current (published) state of research in pain-relieving drugs.

Question # 2

Seasonal and Day-of-the-Week Patterns

A number of researchers have discovered that January has been the very odd month for stock market ...