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Efficient Market Theory Definition | Random Walk Theory

The main objective of fundamental analysis and technical analysis, as discussed in the previous chapters, is to find out the state of the economy, the details of the company whose stocks are to be purchased and the industrial classification and growth of the industry to which the company is concerned. . Apart from this, fundamental analysis is also related to the financial statements of the company through ratio analysis and earnings per share. Technical analysts reject the work of fundamental analysts on the grounds that they do not pay attention to stock price trends in the market. Technical analysts believe that the past trend of stock prices provides information about a stock's future. He studied the pattern of stock prices through charts and estimated through patterns. His method gives information about the types of stocks to buy at the start of a bull market or a bear market (Tejadia or Beard). Investment Risk 

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Efficient Market Theory Definition

On the basis of technical analysis many researchers have asked the following questions

  • (i) Does today's stock price give any indication about tomorrow's prices?
  • (i) Does the actual value of the stock have any significance?
  • (iii) Is it related to the stock price?

These questions were explained through an analysis Random Walk Theory. This theory discusses the efficiency of capital market.

Efficient market theory tells us that changes in stock prices are coincidental. (randomly) occurs. It does not follow any regular pattern.

Efficient Market Theory Definition |  Random Walk Theory
Efficient Market Theory Definition |  Random Walk Theory

Efficient Market Basic Concepts

Before understanding Random Walk Theory, we should know about Market Efficiency, Liquid Trader and Information Trader.

Market Efficiency - Market efficiency is concerned with the actuality and speed with which the market converts investor expectations into share prices. The expectations of investors regarding future earnings are reflected in the prices of the shares. There are two types of market efficiency.

  1. Operational Efficiency.
  2. Informational Efficiency.

(i) Operational Efficiency

The efficiency of the stock market is measured by the time taken to fulfill orders and the number of defective deliveries. The operational efficiency of the market is a matter of concern for investors. This is not taken into account in the efficient market hypothesis.

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(ii) Informative Efficiency

The market receives new information frequently – financial reports, company analysis, political statements and new industrial policy announcements, how the market reacts to these. Security prices adjust themselves quickly and appropriately. For example, the declaration of bonus shares binds the stock prices. Similarly, there is a change in the stock index due to the announcement of the policy decisions of the government.

• Liquidity Trader

Here the investment and resale of shares depends on the individual needs of the investor. Liquid traders can sell shares to pay off their wills. They do not do any kind of analysis before investing.

• Information Trader

These traders do analysis before buying or selling shares. They estimate the actual value of the shares. If the market price of the shares is more than the actual price, then sell the shares and if the market value is less then buy.

Concept Of Efficient Market Theory

Efficient market theory is based on the efficiency of the capital market. It assumes that the market is efficient and that information is available about each stock in the market. There is a proper system of collecting information in the market, due to which the information about changes in prices is continuously received. Every investor gets the same information about the stock market and each security. Therefore, it is assumed that no investor can take consistent profit based on stock prices and the securities will provide the same return at the same risk level.

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  • 1. Perfectly competitive market operates efficiently to bring the actual stock prices at par with their current prices. This means that the par value of the stock is the value of the appraised stock based on information with the investor.
  • 2. Market participants in an efficient market have the same information as investors. Hence the market value of the stock reflects the present value of the stock.
  • 3. According to this theory, the change in stock price is due to some such changes (components) which affect the stock market.
  • 4. A change in price causes an immediate change in the stock price and the stock reaches a new level.
  • 5. The random walk theory is the stock reaching a new parity level due to new Information.
  • 6. Further changes in stock prices result in prices reaching another New Level.

The Random Walk Theory

In 1900, the French mathematician Louis Bachelier wrote an article. According to that article, changes in securities prices are sudden. Every change is independent of the previous change.

The essential truth of the Random Speech Theory is that information about stock prices is spread instantly and therefore the investor is fully aware of it. That is why price movements are independent of each other. Hence it can be said that prices have an independent nature, the daily price may vary – unchanged, or higher or lower than the previous price. Random speech theory gives information about institutional factors and thus the theory is logical.

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According to this theory, financial markets are so competitive that price adjustments occur immediately. This is because of the good communication system as the information reaches anywhere in the country instantly. This speed of information determines the efficiency of the market.

Random speech theory is based on efficient market hypotheses in the weak form of the market. The weak nature of the market tells us that changes in securities prices are sudden.

Efficient Market Hypothesis-EMH

In the 1970s, American economist Eugene Fama described that efficient markets fully reflect available information. If the market is efficient, the security prices reflect the normal return at the specified risk level. According to Fama, the efficient market hypothesis can be divided into three categories such as

  • Weak Form of Market
  • Semi-Strong Form of the Market
  • Strong Form of Market.

This classification has been done on the basis of information available in the market. The following figure shows the market efficiency.

  1. Strong Form of Market (All information is reflected on prices)
  2. Semi-Strong Form of Market (All past and public information is reflected in share prices)
  3. Weak Form of Market (Only past information is reflected in share prices)

Figure : Efficient Market Theory

Weak Form of EMH

In the weak form of the efficient market hypothesis, the information used is based on past prices. Accordingly, the current price of a stock reflects information related to past prices and trading volume. Future prices cannot be predicted by analyzing past prices. Therefore, in the weak nature of an efficient market, past prices do not give any information about future prices. A short term trader or a liquid trader can batch his shares without considering the actual value. These traders can adopt a "buy and hold" strategy. In this way short term traders can get positive returns in the weak nature of efficient market.

Empirical Tests/Evidences of the Weak Form

Numerous studies by market analysts have attested to the weak nature of the EMH. Many empirical investigations have been done on this form such as:-

1. Filter Test

The Filter Rule Test was created by Alexander in 1961 to find out whether extraordinary income can be obtained using past price data. The Fiter Rule Test is designed to work as follows - If the price of a security rises by 'X' percent, the investor should buy it and hold it until the price drops below the previous high. Not equal to less than 'X' percentile. Short term traders can use it to make profit

According to Alexander, the Filter Rule has given investors a higher rate of return. He did a number of filter tests and found that smaller filters of 4.5% provided a higher return rate. But when the transaction cost is included in the purchase price, the unusual profit vanished. The Filter Rule was used by Fama in 1965 and again by Fama and Blumd in 1970. But failed to achieve abnormal return rate. Therefore, Alexander's results did not rule out the weak nature of EMH.

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2. Run Test

Run Test It detects whether the price movements are sudden. Run is a non-blocking sequence of equal signs. Fama also did a run test to know whether the price changes would be of like sign in future. Run Tests are performed by counting consecutive marks or the number of runs in the same direction. For example, +0+ would be said to have 4 runs. Finding the actual number of runs and comparing them with the randomly generated number. The random speech hypothesis was kept aside in this research work. Hagerman and Richmand also studied changes in price and found that income was not chronologically correlated. Granger and Morgenstern used the statistical technique "Spectral Analysis" in 1963 to examine the random nature of stock prices. their income for a period. No relationship was found in the income of the second period.

3. Serial Correlation Tests

Serial Correlation Techniques do independent testing of change. Fama examined the gradual correlation of daily changes in price in 1965. He calculated the sequential correlation of 30 stocks for the period 1958-1962. His research showed an average correlation of -0.03. This correlation was also very weak as it was not very far from zero, therefore, it could not report any correlation between price changes in the previous period.

4. Random Walk Test

Random walk means that the prices have changed today. All of them are independent of the prices they were before today. A number of research studies have been conducted to investigate the vulnerable nature of EMH. The weak form of efficient market theory only takes into account the average change in price today.

4. Random Walk Test

Random Walk means that all the prices which have changed today are independent of the prices before today. A number of research studies have been conducted to investigate the weaker form of EMH. The weak form of efficient market theory only takes into account the average change in prices today.

5. Simulation Test

This research work was done by Robert and Osborne in 1959. Robert compared the level of the Dow Jones industrial average to the variables produced by the random walk technique and concluded that the patterns represented by the random walk technique were of stock prices. The movement was like that. This research work of Robert is also called Simulation Test.

6. Behavior of Commodity Prices

The first research was done by Bechelier in 1900 in this regard. He developed this theory for commodity prices and found that commodity prices follow random walks. Cowles in 1934 and Jones in 1937 and Kendall in 1953 supported this theory and found that securities prices also follow random walks. The research done by these analysts was based on economic data in which they analyzed the statistical properties of data and affected the weak nature of efficient market.

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7. Brownian Motion Test

Osborne's research shows that movement in stock prices is similar to Brownian Motion. Brownian Motion is considered a variant of random walk. According to Osborne's research, the prices of securities fluctuate according to the Brownian Motion Model. This research shows that the change in price during a period is independent of the change in the previous period.

8. Relative Strength Method

This method was formulated by Levy in 1967, which was based on the ratio of the current price of the stock and its average price. This led to the development of a method of analysis that gave abnormal returns. in 1967. Jensen found that Levy's results were biased because he had drawn this result based on only a few of the data he had selected. Jensen and Bonnington further examined Levy's research in 1970 and found that no unusual returns were obtained.

Semi-Strong Form of EMH

The semi-robust form of the EMH highlights all publicly available information about the public company, along with past prices. The semi-strong nature of the market suggests that stock prices change as soon as the information becomes public. Hence the stock prices are adjusted according to the information received. This information may not be accurate. But analysts are not able to make a permanent decision as the price gets adjusted immediately. Sometimes there is over-adjustment in the market and sometime short adjustments also take place. This makes it difficult for analysts to strategize. If right with the analysts. If there is information, then the chances of making profit are more. But profits cannot be earned continuously because

  • (i) Change and return are independent and change in prices are independent of each other.
  • (ii) Prices change frequently.

If new information is received quickly in the market then a new price is seen. semi-strong. For form, the information in the market should be received in the right form on time, only after that the market can bring all the information to light quickly.

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Empirical Tests/Evidences on Semi-strong Form of EMH

EMH experimental test/evidence of semi-strong nature:- Evidence of empirical investigation/strong nature is as follows

Market Reaction Test

Fama, Fisher, Jensen and Roll (1969). He was a pioneer in assessing the semi-strong nature of the EMH. He analyzed the effect of stock split on the share price. His study is important because of the following reasons:

  1. It provides evidence of the semi-solid nature of the market.
  2. It also analyzes if the stock sharing leads to an increase in the wealth of the shareholders. 
  3. It helps researchers in checking market efficiency.

From this research study it is found that the information of the stock split before its announcement gives a reaction in the market.

Price Change Test

In 1972, Scholes conducted this study to find out the "response of the security price to the offer of the subsidiary stock". He analyzed the price effect on the larger offerings of the subsidiary market. Prices often fall before subsidiaries. This is due to the effect of information and not because of selling pressure. If large volumes of sales are related to the company's members and offers, the fall in prices will be rapid. If this sale is related to other groups, then the decline will be small.

Effect of Large Trade on Prices

In 1972, Krans and Stoll did research to investigate the “Effect of Large Trade on Securities Prices”. According to him, research has shown that it has a temporary effect on share prices. The effect of large volume trading was seen in the form of a "price drop" but there was an immediate rise in prices – but prices did not return to their previous levels because information had entered the market which had a negative impact on the security's image.

Announcement Effects

Beaver studied the “speed of change in securities prices of announcement of annual earnings”. He checked the level of trade volume and quantity of price changes. According to him, during the announcement week there was complete change in price and trading levels were high. However, in the next week this level came down to pre-announcement levels.

Strong Form Of EMH

The strong nature of the EMH tells us that securities prices reflect complete information. This form of EMH suggests to us that forecasting prices futures is not profitable for any investor or analyst because he cannot get a better return than a good return for others. Every investor is aware of new market information and analysts cannot consistently get good returns despite having inside information. The hypothesis of a strong efficient market is not acceptable. This is the culmination of the efficient market hypothesis. This hypothesis tells us that even risk analysts and portfolio managers, who have more information than the average investor, are not able to make high profits.

Empirical Test/Evidences of Strong Form of EMH

Much of the research has shown that the efficient market hypothesis does not bode well for a strong market. Many uses of the strong form of EMH are related to mutual fund performance. Some uses are as follows:-

Collins Test

In 1975, Collin examined the robust nature of the market. According to Collin, the consolidated income of a multi-product firm was estimated by using segment and profit data instead of the previous consolidated income data. can go. Collin tried to do research work using market model.

Mutual Fund Performance

The performance of mutual funds was examined by Friend in 1972, Sharpe in 1966 and Jensen in 1969. Blume and Crockett and Williamson studied this further. The hypothesis in this regard was that, 'Mutual funds can yield exceptional returns and achieve higher than average performance because they have insider information. which is not publicly available.

The research study revealed that the performance of mutual funds was not good for an individual investor. Jensen studied 115 mutual funds. He concluded that the mutual funds are not able to estimate the income correctly to meet the research and operation cost. He considered this as evidence for the strong nature of the EMH.

Market Inefficiencies

Many studies have proved the existence of market efficiency. These studies have negated the concept of efficient market. It can be discussed as follows:-

1. Overreactions of the Market

Recent studies have shown that the market over-reacts to corporate news. The market overreacts if the company announces a reduction in earnings or the closure of the unit. In such a situation the stock price may fall. After the initial drop, it takes several weeks for the stock price to reach normal levels. During this period, the investor can buy the stock at a lower price and sell it when the price reaches the normal level. This strategy helps him to get unusual income which is against the efficient market imagination.

2. Reversals to Average Return

Some studies have shown that stock earnings tend to return to their average level. Stocks which are earning low now yield high returns in future. Similarly, stocks which have good current performance may provide less return in future. Income can then come back to its average level. This provides an opportunity to forecast future prices which is contrary to the random walk principle.

3. Delayed New Information

Often the stock prices show immediate reaction on receipt of the information. It has been proved from research that the stock prices rise continuously for some time after good profit is declared. Similarly, stock prices continue to fall for some time after reporting lower profits.

4. Small Firm Effect

The theory of small firm effect tells us that investing in a small firm gives better income. According to Benz, the size of the firm is related to the income. Benz investigated monthly earnings of NYSE ordinary stock for the period 1931–1975. He prepared a portfolio of 10 small firms and 10 large firms and calculated the average income of the portfolio. Portfolio of smaller firms performed better than portfolio of larger firms

5. The Weekened Effect

French examined the income earned by the SRF index for each day of the week. Stock prices continued to rise throughout the week, hitting their all-time high on Friday. Usually on Monday the stock trades at a lower price. The annual average return from buying on Monday and selling on Friday (from 1953 to 1977) was 13.4 percent, while the return rate under the buy-and-hold policy was 5.5 percent. Information about the Weekend Effect is important for investors.

6. Low Price-Earnings Effect

Many studies have shown that stocks which have low price-earnings ratio provide more returns than those stocks which have high price-earnings ratio. . This is known as the low price-earnings effect. If previous information about the price-earnings ratio helps the investor to generate higher returns, it calls into question the validity of the semi-strong nature of the market hypothesis.

Random Walk Theory 

Conclusions of Random Walk Theory According to this theory, successive changes in price or change in return/income are independent of each other. The random speech model tells us that stock prices reflect all publicly available information. Stock prices get adjusted (more or less) based on new information. This theory mainly deals with the successive changes in price rather than the price or income level.

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This theory also suggests that information about changes in prices alone is useless for profit making. In addition to past stock prices, the investor or analyst should have other reasonable information.

Investors should note that this theory does not provide information about market price movements, industry or other factors. The random speech hypothesis is concerned only with the change in price and not with the associated prices. Changes in price can be sudden but it does not mean that there will be no further upward or downward trend in prices

Random speech theory suggests that analysis should be done after considering:-

  • 1. To find out the risk and return characteristics of each security
  • 2. Integrate the risk and return characteristics of the security into a proper and adequate portfolio
  • 3. Hold the portfolio for a reasonable period and evaluate the securities regularly
  • 4. Build a Facilitated Portfolio and Reevaluate It When Necessary.

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