THE EMPIRICAL FOUNDATIONS OF THE EMH

Like the theoretical evidence for the efficient market hypothesis, the empirical evidence also appeared to be strong during the 1960s and the 1970s. In general terms, the empirical expectation of the efficient market hypothesis can be divided in two broad categories: First, when new information about a security is received, the price reacts as it quickly incorporates the new information.

The principal hypothesis resulting from the quick and accurate reaction of prices to new in­formation is that late information is of no value in making money, where making money is defined as obtaining a higher return after revaluation of the income with a risk adjustment ratio. In this case, the problem is to define an adequate level of risk. This can be measured by a model of fair relation between risk and return, like the capital asset pricing model. It implies that the test can fail because either one of the two hypotheses is false or because both parts of the joint hypothesis are false (Cornicello, 2004, p.9). In general, when the joint hypothesis is rejected, this could be due to deficiencies in the asset pricing model rather than the efficient market hypothesis which is as mentioned before “bad model problem.”

Returning to the informational efficiency view, it is necessary to express the informational efficiency of Fama in detail. The three different forms of the efficient market hypothesis were introduced by Eugene Fama in 1965: the weak, the semi strong, and the strong in detail.

The weak form of the efficient market hy­pothesis: It is also known as the random walk model and has received much attention among the academics and investment practitioners for years. Noteably, hypothesis dates back to Bachelier’s doctoral dissertation about the of stock prices behavior. But the academic debate over the subject has accelerated after the doctoral dissertation of Fama in 1965. (Hagin 2004, p.55) Random walk hypothesis asserts that the random nature of stock prices can not reveal trends thus there is no way of predicting future prices using past prices. It has become widely associated with the efficient market hypothesis through the work of Fama. It holds that present stock prices reflect all known information with regard to past stock prices, trends, and volume. The weak form implies that knowledge of past stock patterns does not assist investors in obtaining improved performance. Random walk theorists view stock prices as moving randomly about a trend line that is based on rational expectations regarding fundamental factors. Proponents of this view feel that analyz­ing past data does not permit technical analysis to accurately forecast movements of the prices about the trend line. In addition, new information affecting stock prices enters the market randomly. No predictability exists with regard to news that would affect a stock’s price.

The semi-strong form of the efficient market hypothesis: This form of the market efficiency hypothesis states that current market prices instantaneously reflect all public information. This form reflects a substantially greater level of knowledge and market efficiency than does the weak form. The semi strong form would seek to test whether all publicly available information and announcements are quickly and fully reflected in the market prices of stocks. The shifts from the weak to the semi strong form of the efficient market hypothesis represents a remarkable jump.

The strong form of the efficient market hypoth­esis: The strong form holds that present market prices reflect all information that is legally possible to achieve about a company. This includes analysis and also any exhaustive studies by institutional financial analysts. According to this form of the efficient market hypothesis, consistently abnor­mal return performance by market participants is impossible (Hollman, 2005, p. 22). The strong form moves the efficient market hypothesis to a still higher level of information and knowledge. The strong form constitutes a direct challenge to the institutional investor, the most integrated seg­ment of the financial community. Also the strong form of the efficient market hypothesis can be seen as an extension of the semi strong form of the efficient market hypothesis.

Random Walk Hypothesis

The EMH says that the entire history of informa­tion regarding a financial asset is reflected in its price and that the market responds instantaneously to new information. According to the EMH, if any patterns exist, they must be so small that no systematic trading strategy can have a better risk/ return profile than the market portfolio. That is to say, no one can make abnormal returns in the market. Athanasoulis and Shiller (1997) analysed the significance of the market portfolio with dif­ferent assumptions.(p.4) Therefore, according to the EMH, no profitable information about future movements can be obtained by studying past price-series. Starting from the there is no riskless gain in financial markets, it is sensible that proponents of the the EMH would choose a model of asset prices that constitutes a “random walk” in price-space. In modern finance theory, theoretical descriptions are mainly based on the assumption that asset prices follow some form of random walk (Johnson, Jefferies, & Hui, 2003, pp. 20-21).

The theory of random walk in stock prices involves two separate hypotheses:

• Successive price changes are independent.

• Price changes conform to some probability distribution.

Independence means that the sequence of price changes leading up to the time period have no influence on the probability distribution of the stock’s price. Consequently, in a financial market using a strategy based on past prices data, it is not possible to obtain higher a return than a buy and hold strategy (Cornicello, 2004, p. 10).