• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

Discuss the empirical evidence supportive of and against market efficiency.

Extracts from this document...

Introduction

1) Discuss the empirical evidence supportive of and against market efficiency. The efficient market hypothesis (EMH) predicts that market prices should incorporate all available information at any point in time (Clarke, Jandik and Mandelker, p.9). A market is seen as efficient if it incorporates all new information in its security prices in a rapid and unbiased manner, meaning investors should not be able to systematically outperform the market. Different kinds of information influence the security values. Hence, there are three versions of the EMH depending on the information assumed to be impounded in prices. weak form: share prices fully reflect the information implied by all prior price movement (Clarke, Jandik and Mandelker, p.10). semi strong form: share prices respond instantaneously without bias to newly published information. (Clarke, Jandik and Mandelker, p.10). strong form: eshare prices fully reflect not only published information but all relevant information including data not yet publicly available.(Clarke, Jandik and Mandelker, p.10). Since the introduction of the EMH, extensive empirical research has been done towards the EMH, with evidence both for and against it. Evidence in favour of the EMH Tests of weak form efficiency originate from the random walk theory, which implies that successive price movements should be independent; future stock prices cannot be predicted based on past stock prices (Clarke, Jandik and Mandelker, p.12). ...read more.

Middle

Futhermore, Rolf Banz uncovered a anomaly in 1981; he found that small firms tend to have higher abnormal returns than do larger firms. Subsequent research indicated that most of the difference in returns between them occurred in the month of January (Clarke, Jandik and Mandelker, p.20). There is no evidence that small stocks are much riskier in January, therefore, since both a company's size and coming of the month of January is information known to the market, the excess returns based on stale information, contrasts the semi strong form efficiency hypothesis. Although no theory is perfect, the is an abundance amount of evidence supporting the EMH, at least in the weak and semi-strong form efficiency. However, the substantial noise that is apparent in the markets have led academic researchers to turn to other theories. 2) Discuss the behavioural challenge to market efficiency. As mentioned, the EMH assumes that decision makers are considered to be rational and utility maximising. However, in reality, there are many instances where emotion and psychology influences peoples decisions, causing unpredictable or irrational behaviour. This had led to the emergence of behavioural finance, which provides reason for some of the anomalies mentioned in part 1 and hence questions the conventional methods of modelling investor behaviour. ...read more.

Conclusion

Moreover, as regret aversion suggests, regret of a bad investment is lower when you know other have make the same mistake. Herding can lead to speculative bubbles, which historically have resulted in stock market crashes. People base their decisions on what the herd does, instead of rigorous analysis. When such psychological biases exist, the market swings on the basis of very little information, which can push stock prices far above their actual worth (Nofsinger 2002, p.80) Challenge to EMH Such psychological behaviors affect the EMH in a number of ways. Moreover, if the theory behind behavioral finance is in fact correct, we can assume a number of possible behavioral patterns within financial markets. These patterns include: an over or under-reaction to price changes or news, extrapolation of past trends for future, lack of attention to fundamentals underlying a stock, target on popular stocks, and seasonal price cycles (Brabazon 2000, p.6).The implications of these patterns provide a basis for investors to exploit pricing anomalies as means of obtaining superior risk adjusted returns, challenging the EMH. On the other hand, Fama argues that prices are just as likely to over-react as they are to over-react (Shleifer 2000, p.47). They are chance events that will balance each other out overall, suggesting that the EMH is still accurate and relevant. Further, these anomalies from irrational behaviour is argued to be met by other rational investors where arbitrage will drive prices back to their ?correct? level. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our University Degree Applied Economics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related University Degree Applied Economics essays

  1. Economic analysis and PESTLE for a London hotel and restaurant.

    The telegraph * Necessities and luxuries: Necessities demand curve are more inelastic in nature whereas luxury demand curve are more elastic in nature. For e.g. vacation airline ticket would be more elastic rather than business tour airline ticket which would be inelastic in nature.

  2. The dotcom bubble and the stock market fall in 2000-2001

    To begin with, let's define the key term. What is a dotcom? Dotcom is a firm conducting its business mainly over the Internet. They usually possess a Web site intended for business use. The term is based on the "com" that forms the last part of the address for most commercial Web-sites.

  1. Transaction cost economics. Ronald Coase set out his transaction cost theory of the firm ...

    Research that attempts to measure transaction costs is the most critical limit to efforts to potential falsification and validation of transaction cost economics.

  2. Econometrics Case Study. The main objective of this project is to apply the econometrics ...

    =w2t Since the probability of the F-test = 0.0000 is lower than the significant level (?=0.05).) then we reject null hypothesis at that significant level . It means that there is autocorrelation and the estimated parameter is not efficient .One Potential solution is to do remedy .

  1. .The focus of this essay will be on developing a marketing strategy for Classic ...

    PED = %?Qd /%?P (PED=20/-10) Graph 1.41 1-http://en.wikipedia.org/wiki/Price_elasticity_of_demand Income elasticity of Coca cola is the response of demand in quantity to change of consumers income .During the period of decline in consumers income ,the demand of coca cola also declines,as Coca cola is not considered to be a basic necessity for consumers , instead the

  2. Economics Questions on Entrepreneurs, Equilibrium Pricing. Markets and the Labour Supply Curve.

    Monopolists will try to create barriers in order to prevent various other companies from coming into the market. A strong influence will be exerted onto the price that which they will charge for the product. Yet since monopolists are the solitary supplier of the product then it doesn?t mean that control of what is charged is whatever they think.

  1. Economics- market failure

    reducing by and a timescale for implementing, amending and forward planning for greater efficiency. New techniques and technology are being developed to allow the government to maximise resources and minimise waste. This allows for products and processes that require less raw materials, water and energy and produce less waste also reusing the waste which is produced.

  2. Outline and discuss recent (1999-present) trends in the size of government and the composition ...

    Consequently, the costs, taxes, are seen to exceed the benefits of public goods. As a result only when public officials can hide the costs of policies in a ?fiscal illusion? can they spend large amounts without displeasing the public. Buchanan and Wagner (1977)

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work