Study On Efficient Market Hypothesis Finance Essay

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Efficient Market Hypothesis (EMH) is the theory behind efficient capital markets. An efficient capital market is one in which security prices reflect and rapidly adjust to all new information. The derivation of the EMH is mostly credited to the work of Fama.

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In 1965 the doctoral dissertation written by Fama was republished. In this Fama looks at the current literature on stock price behaviour and examines the distribution and dependence of stock price returns. He concluded that, ‘it seems safe to say that this paper has presented strong and voluminous evidence in favour of the random walk hypothesis.’ Due to a better understanding of price formation in competitive markets, the random walk model was now seen as a set of observations that can be consistent with the efficient markets hypothesis. This switch began with observations published in a paper by Samuelson in 1965. Samuelson presented his proof in the general form, which helped in the understanding of the notion of a well-functioning market. His paper had the observation ‘in competitive markets there is a buyer for every seller. If one could be sure that a price would rise, it would have already risen.’ Samuelson stated that ‘arguments like this are used to deduce that competitive prices must display price changes…that perform a random walk with no predictable bias.’ Following on by the work done by Samuelson, as mentioned in the previous paragraph, a paper was published by Fama in 1970. This paper consisted of a comprehensive review of the theory and evidence of market efficiency. He defined an efficient market as ‘one in which trading on available information fails to provide an abnormal profit.’ This paper was one of the firsts to distinguish between the three forms of market efficiency. The three forms of market efficiency are the weak form, semi-strong form and strong form. He concluded that the results are strongly in support of the weak form of market efficiency and that in short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse. I will now summarise some papers that have been written on the criticism of the EMH. Although there has been a vast amount of literature published on the development and the support of the efficient market theory, there has also been various studies published criticising the EMH. This criticism comes about due to the fact that the EMH is difficult to test. A number of studies indicate anomalous behaviour, which appears to be inconsistent with market efficiency. Such anomalies include the small firm effect as talked about in a paper by Banz in 1981. Banz analysed monthly returns over the period 1931-75 on shares listed on the New York Stock Exchange. Over this interval, the fifty smallest stocks outperformed the fifty largest by an average of one percentage point per month,

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