Literature review on efficient markets.

Authors Avatar

Literature review on efficient markets

Abstract

This article is mainly does a thorough review of the efficient market from 1960’ to now. This article tries to discuss efficient market historically and theoretically. In the historical part, mainly introduce the theory development by timeline. And in the theoretical part, review the model of efficient market, and discuss some empirical research on the CAPM. The third part is maily about different ideas on efficient market, some criticism show up when the economy developing and the market becoming more and more mutual while there are also more and more problems revealed. And then comes to the conclusion.

  1. Introduction

The efficient market hypothesis (EMH) is one of the corner stone of modern financial economics. An efficient market is one in which securities prices reflect all available information. This means that every security traded in the market is correctly valued given the available information. The efficient market hypothesis (EMH) tests the assumption that stock markets reflect the available information in the stock prices. A market is said to be efficient with respect to an information set if the price ‘fully reflects’ that information set (Fama,1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992).The efficient market hypothesis (EMH) asserts that financial markets are efficient. A market that incorporates available information into its prices is known to be efficient. The EMH also suggests that in efficient markets there is little or no scope for arbitrage opportunities as the market quickly adjusts to new information (Vasicek and McQuown 1972, pp. 71-84).

This theory started with the largely unknown work of Louis Bachelier (A french mathematician). However,  at first there is not much attention has been allocated for this proposition until 1964 an American Economist, Samuleson proposed it again in his dissertation, with several controversies in his adoption. In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis. And then in 1970, Fama do several studies to prove the idea that could not reject the significant power of this theory. Jensen (1978) also believes that "There is no other theory with as much economical background as the Efficient Market hypothesis". Some studies depicts the market as an intelligent agent with an invisible hand (similar to the concept of Adam Smith) that is able to correct the speculative movements in price processes as described in Poterba and Summers (1988).

This article will do a literature review on the efficient market hypothesis both historically and theoretically. And with the development of economy and study going further and further, there are different voices appear. Some critical point will also be discussed in this article.

  1. Historically

If there is to be one “father” of the efficient market hypothesis, this man is Eugene Fama, who remains an outspoken proponent of the hypothesis to this day. In Fama (1970, 1991, 1998), he gave comprehensive overviews of the literature on the topic. But before Fama, there are also a lot of works done to approach this theory.

Back in the 16th century the prominent Italian mathematician, Girolamo Cardano, in The Book of Games of Chance (Cardano, c. 1564) wrote: ‘The most fundamental principle of all in gambling is simply equal conditions, e.g. of opponents, of bystanders, of money, of situation, of the dice box, and of the die itself. To the extent to which you depart from that equality, if it is in your opponents favors, you are a fool, and if in your own, you are unjust’. In 1900 a French mathematician, Louis Bachelier, published his PhD thesis, Th´ eorie de la Sp´ eculation. He deduced that He deduced that ‘the mathematical expectation of the speculator is zero,’ which is 65 years earlier before Samuelson (1965) explained efficient markets in terms of a martingale. In 1944, Cowles reported that investment professionals do not beat the market (Cowles, 1944). Holbrook Working showed that in an ideal futures market it would be impossible for any professional forecaster to predict price changes successfully (Working, 1949). And then Larson (1960) presented the results of an application of a new method of time series analysis in which notes that the distribution of price changes is ‘very nearly normally distributed for the central 80 per cent of the data, but there is an excessive number of extreme values.’ Fama and Blume (1966) concluded that for measuring the direction and degree of dependence in price changes, serial correlation is probably as powerful as the Alexandrian filter rules. In 1968 Michael C. Jensen evaluated the performance of mutual funds and concluded that ‘on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses’ (Jensen, 1968). Fama et al. (1969) undertook the first ever event study, and their results lend considerable support to the conclusion that the stock market is efficient.

Eugene F. Fama’s published the definitive paper on the efficient markets hypothesis first of three review papers: ‘Efficient capital markets: A review of theory and empirical work’ (Fama, 1970). He defines an efficient market thus: ‘A market in which prices always “fully reflect” available information is called “efficient.”’ He was also the first to consider the ‘joint hypothesis problem’. The efficient markets theory reached its height of dominance in academic circles around the 1970s. At that time, the rational expectations revolution in economic theory was in its first blush of enthusiasm, a fresh new idea that occupied the center of attention. The idea is that speculative asset prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information meshed very well with theoretical trends of the time. Prominent finance models of the 1970s related speculative asset prices to economic fundamentals, using rational expectations to tie together finance and the entire economy in one elegant theory. For example, Robert Merton published "An Intertemporal Capital Asset Pricing Model" in 1973, which showed how to generalize the capital asset pricing model to a comprehensive intertemporal general equilibrium model. Robert Lucas published "Asset Prices in an Exchange Economy" in 1978, which showed that in a rational expectations general equilibrium, rational asset prices may have a forecastable element that is related to the forecast ability of consumption. In the years from the 1950s to the 1970s, most studies based on the CAPM and fair game models found evidence consistent with the efficient market hypothesis. Ball (1978) wrote a survey paper which revealed consistent excess returns after public announcements of firms’ earnings. Jensen (1978) wrote, ‘I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.’ He defines efficiency: ‘A market is efficient with respect to information set θt if it is impossible to make economic profits by trading on the basis of information set θt.’ Robert E. Lucas Jr. built a theoretical model of rational agents which shows that the martingale property need not hold under risk aversion (Lucas, 1978).

Join now!

After coming into the 21st century, the theory develop rapidly to go further research. Lewellen and Shanken (2002) concluded that parameter uncertainty can be important for characterizing and testing market efficiency. Chen and Yeh (2002) investigated the emergent properties of artificial stock markets and show that the EMH can be satisfied with some portions of the artificial time series. Malkiel (2003) examined the attacks on the EHM and concludes that stock markets are far more efficient and far less predictable than some recent academic papers would have us believe. G. William Schwert showed that when anomalies are published, practitioners implement ...

This is a preview of the whole essay