Research On The Importance Of Market Efficiency Finance Essay

Research On The Importance Of Market Efficiency Finance Essay Liquidity is a very desirable characteristic for a financial market product. Moreover, efficient market is one where the market price is an unbiased estimate of the true value of the investment. The concept of efficiency is central to finance. Primarily, the term efficiency is used to describe a market in which relevant information is impounded into the price of financial assets. Efficiency is central to finance. Market efficiency is guided by two principles which are Information and competition. Systematic and good market efficiency leads to market pricing .Any buyer who is willing to buy a product wants to be fully satisfied with the product that the seller is selling to him. Past, present and even discounted future events are reflected in market price but often show no apparent relation to price changes. Efficient markets hypothesis does not rule out small abnormal returns, before fees and expenses. Analysts could therefore still have an incentive to acquire and act on valuable information, though investors would expect to review no more. Only new information should affect stock prices, price changes are random and unpredictable.While it was clear that markets cannot completely be efficient in the strong forms, there was striking support for the weak and semi- strong forms. All investors aim to maximize economic utility (in other words, to make as much money as possible, regardless of any other considerations). This is a key assumption of the efficient market hypothesis The Buyers know that what is going on in the market and what is the price everywhere All investors have access to the same information at the same time. This also comes from the efficient market hypothesis. In fact, real markets contain information asymmetry, insider trading, and those who are simply better informed than others boooks se shareholders.. Importance of market efficiency It is important to understand how securities are valued because these principles provides values to the managers to keep up in managing the business in good way as it can help in dealing with the owners best interest. If stock prices are formed inefficiently, that creates the potential for inappropriate investments in the economy. If stock prices accurately reflect future firm performance, then this creates the premises for efficient resource allocation. Even if sometimes errors are made in valuation, markets can be efficient. Even if many market participants are irrational, markets can be efficient. Markets dont allow investors to earn above-average risk-adjusted returns. Implications of market efficiency They suggest that markets reach quickly to the new public information. The conditions required for markets to exist are No one investor can affect the price of the security through their own buying or selling. Information is available to the market participants all time. Investors react quickly and fully to the new information Efficient Market Hypothesis The theory that markets are efficient and all available information keeps on fluctuating with the price at any given time. It reflects all information both public and private which means all the sectors. It is associated with idea of random walk which means that if the flow of information reflects the stock prices then next days prices will reflect only next days news and will be independent of price changes today. IMPORTANCE OF EFFICIENT MARKET HYPOTHESIS Stakeholders can determine the effectiveness of the appointed management by observing the stock price. Anomalies The ease of experimenting with financial databanks of almost every conceivable dimension makes it quite likely that investigators will find some seemingly significant but wholly spurious correlation between financial variables or among financial and nonfinancial datasets. Moreover, the published literature is likely to be biased in favor of reporting such results. Significant effects are likely to be published in professional journals while negative results, or boring confirmations of previous findings, are relegated to the file drawer or discarded. Data-mining problems are unique to non experimental sciences, such as economics, which rely on statistical analysis for their insights and cannot test hypotheses by running repeated controlled experiments. Share prices can be highly sensitive as a result of rational responses to small changes in interest rates and risk perceptions. Suppose stocks are priced as the present value of the expected future stream of dividends. For a long-term holder of stocks, this rational principle of valuation translates to a formula: r = D/P + g, Where r is the rate of return, D/P is the (expected) dividend yield, and g is the long-term growth rate. For present purposes, consider r to be the required rate of return for the market as a whole. Suppose initially that the riskless rate of interest on government bonds is 9 percent and that the required additional risk premium for equity investors is 2 percentage points. In this case r will be 11 percent (0.09 + 0.02 = 0.11). If a typical stocks expected growth rate, g, is 7 percent and if the dividend is $4 per share, we can solve for the appropriate price of the stock index (P), obtaining 0.11 = 07.04$+P P = $100. Now assume that yields on government bonds rise from 9 to 10 Â ½ percent, with no increase in expected inflation, and that risk perceptions increase so that stock-market investors now demand a premium of 2 Â ½ percentage points instead of the 2 points in the previous example. The appropriate rate of return or discount rate for stocks, r, rises then from 11 percent to 13 percent (0.105 + 0.025), and the price of stock index falls from $100 to $66.67: 07.013.04$+=P 67.66$=P The Performance of Professional Investors Most convincing tests of market efficiency are direct tests of the ability of professional fund managers to outperform the market as a whole. Surely, if market prices were determined by irrational investors and systematically deviated from rational estimates of the present value of corporations, and if it was easy to spot predictable patterns in security returns or anomalous security prices, then professional fund managers should be able to beat the market. Direct tests of the actual performance of professionals, who often are compensated with strong incentives to outperform the market, should represent the most compelling evidence of market efficiency Empirical Evidence Weak form efficiency is very well supported, and it is reasonable to conclude that markets are weak form efficient, although a few anomalies do exist.All information that can be derived from past performance: prices, trading volumes Semi-strong form efficiency is well supported; however, more contradictory evidence exists for this version of the EMH than for the weak form.Fundamental information, quality of management, accounting standards. Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest sense.All information about a firm, including information available only to insiders Active portfolio management Serious analyses could to pay off but they come at a very high cost and are only feasible for the managers. Passive Portfolio Management Invest in a well diversified portfolio without attempting to outperform the market. It is suggested by Efficient Market Hypothesis as compared to active portfolio management. . Elements of market efficiency Operational Efficiency The transaction cost are low which enhances the trading of securities Informational Efficiency It is one of the most important efficiency as compared to other two as it quickly reflects the market price Allocational Efficiency Securities to allocate risk Implications for investors Technical analysis TO BE REWWARDED Fundamental analysis UNLIKELY TO BE GENERATING ABNORMAL PROFIT. Investors should focus on an investing which gives them good return. Active trading strategies -UNLIKELY TO OUTPERFORM PASSIVE BUY AND HOLD STRATEGIES Implications for Corporate Finance Stock prices at historical lows are likely to go up Mean reverting interest rates means that when interest rates are high based on historical levels they are likely to come down Implications of regulators Holders of securities in a company should be treated in a fair and equitable manner Accounting and auditing standards should be of a high and internationally acceptable quality CONCLUSIONS That an efficient market is one that reacts quickly and relatively accurately to new information, and therefore its prices are correct on average. That the Efficient Market Hypothesis (EMH) is tested in three forms; weak, semi-strong and strong. That empirical evidence suggests that markets are reasonably efficient, but not perfectly so. Investors and corporate officers should modify their behaviours and expectations in light of the evidence of market efficiency. As long as stock markets exist, the collective judgment of investors will sometimes make mistakes. Some market participants are less than rational. The market cannot be perfectly efficient or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices Grossman and Stiglitz (1980). Undoubtedly, with the passage of time and with the increasing sophistication of our databases and empirical techniques, we will document further apparent departures from efficiency and further patterns in the development of stock returns. But I suspect that the end result will not be an abandonment of the belief of many in the profession that the stock market is remarkably efficient in its utilization of information. If any $100 bills are lying around the stock exchanges of the world, they will not be there for long.