An efficient market is that which information is used in reflecting the financial prices. This paper will explain the literature of market efficiency taking into consideration the features that make the market to become efficient. Here, the history and development of market efficiency will be evaluated taking into consideration the efficiency hypotheses. In addition, the issue will be addressed in relation to the capital asset pricing model (CAPM), and bring about information on how the model has become effective. A conclusion will then be provided to create a summary and better understanding of the theory of market efficiency.
Features of market efficiency
The history of market efficiency in relation to finance is enhanced based on the feature of securities within the market. Investors have for long times have considered the security markets that enhance the aspect of market efficiency. The history of market efficiency is thus related with the literature that has for years been discussed by authors in the subjects of mathematics and economics, as well as operation research and statistics. In discussing the history and development of market efficiency, the random walk and three levels of efficiency hypotheses will be explained.
Random walk model
The model is related to the scenario where a drunken person, once left in an open field will stagger randomly. The possibility of the person ending up in the same or close position to where he or she was let is higher than getting the person in a place far away from the position where the person was left. The situation can be related in the finance field where economics get to study the price changes. Financial asset prices over a certain period of time get to fluctuate randomly making it difficult for the economics to predict future market prices (Dimson and Mussavian, 1998, pg 92-93). Some of the authors analyzed the technicians’ use of raw materials to predict future prices, and some used academics to carry out experiments that were used in the laboratory with the purpose of predicting the future stock prices.
The precise nature of random changes in prices is not always the case that the random walk theory tends to explain. The reason for this aspect is that there are price changes that fluctuate in a manner to explain the capture of certain paths that the stock prices follow over time. The study of prices changes provides the economists with an opportunity to future stock prices in the market, not because of techniques used in predicting the prices or because of academic experiments in the laboratory, but because of the nature of price change in certain markets over certain periods in time within the market. This is a series that prices follow, and this provides an environment where prices can be predicted based on the paths that the price changes have been following over time. However, Kendall and Hill (1953) seek to explain the nature of importance in getting to observe the interval of price fluctuations. This is an important aspect that allows economics to understand the possibility of making errors that would affect price change.
Three levels of efficiency hypotheses
The concept of efficiency is well explained by the formation of prices in the markets that are more competitive. Random fluctuation of prices is facilitated within the competitive market. Research carried out on the review of market efficiency enhances development of the theory by being a reflection of market information that is essential for the investors who work in accordance to the price and returns expected and minimization of risks. The second level after the market efficiency concept is the event studies. This is a hypotheses that addresses the stock performance taking into consideration the time taken to measure the stocks and enhance market adjustments. The event studies use the CAPM and market models to enhance price adjustments to prices and earnings that enhance market efficiency. In the event studies, it is important to consider means through which information is effectively interpreted with the purpose of revealing the market situation (Klem and Bawa, 1977, pg 104). The third and final level of the efficiency hypotheses is the strong form efficiency that enhances identification of more information that is essential in creating profits. Market efficiency development can therefore be enhanced through the evaluation of the CAPM that is essential in the development and improvement of performance in efficiency. Performance measures are determined by the managers who have to incur costs for funding the performances, and also gross returns on firms before expenses (Dimson and Mussavian, 1998, pg 96-98). Nevertheless the concept of market efficiency is weak because it is based on historical information. An event study is semi strong because it seeks to explain adjustments in prices based on information that is available within the market. The strong form of tests is that which more information is used to enhance review of empirical information that is stronger than the historical information (Fama, 1970, pg 388)
Effectiveness of the model in the 21st century
In analyzing the aspect of market efficiency, it is important to consider the capital asset pricing model (CAPM) that provides specifications that enhance testing of the market hypotheses (Sharpe, 1964, pg 433). Banz (1981, pg 3) states that there are market inefficiency may bring about anomalies, but the anomalies may be the results of poor testing of market efficiency hypotheses that offer bad specifications for the pricing model. Thus, in enhancing market efficiency, economies are advised to consider the pricing model. A market that is efficient has a reliable source of information that is essential in ensuring that the investors get to invest in certain firms. In situations when securities offer less information to the investors, the possibilities of attracting such investors is low. The reason behind this is the fact that risk estimation is high because no concrete information is provided for the investors to consider in investing. Lack of information brings about uncertainty and the investors lack means through which the securities would bring about returns to the investors (Banz, 1981, pg 17).
Taking the technical trading aspect of firms, the size of the firms matter on the effects they have on risk adjusted returns. The size effect is explained using the pricing model that enhances and explains the variability of risk, as well as determine causes of risks (Chan and Nai-fu, 1988, pg 316). According to Keim (1982, pg 14), size premium sometimes causes abnormal returns and it is important for costs to determined in decision making based on the size of a firm. Keim explains the nature of abnormal returns that are influenced by the size of the firm. It is clear that large firms trade more shares compared to small firms, and the frequency of trading is also enhanced by the size effect. This is the reason why Banz (1981) insisted on the need of information in determining the kind of firms that investors get to invest in without fear of risk of returns.
The pricing model is not only a function of risk, but also a function of the market value of equity. Nevertheless, there are some factors that have not yet been studied and researchers have not yet tested in determining the extent to which the pricing model affects market value of equity in relation to the size of the firm. Trading is also seasonal and there are periods in the year when the stock returns vary. The random walk model is an important aspect that explains the seasonality of trading. This is still influenced and affected by the information that the firms offer to the investors. The random walk of stock returns shows the variation of portfolio returns that differ temporarily in different months of the year. The relation on size effect and returns is not stable over different years because the factors that affect the relationship vary from one year to another. Nevertheless, the large firms are always ahead of the smaller firms in terms of performances in the trading aspect (Keim, 1982, pg 28).
Higher risk stocks as those from smaller firms have the prices being lower that earnings, and research shows that the source of the risk is not a determinant of the earning and price ratio that determines the extent to which average returns on stocks are determined (Fama and French, 1992, pg 428). In enhancing market efficiency, only positive values are associated with positive returns on the earning price ratio determination. When firms experience negative earnings, their expected returns cannot be compared to the returns of firms with positive earnings. To enhance positive feedback in trading, certain price behaviors are observed where market adjustments are done thus enhancing positive returns (DeBondt and Thaler, 1985, pg 798). Fama and French (2006, pg 3) states the CAPM model is important in capturing premiums on value stocks that are higher than the growth stocks. This is an important aspect in determining the returns with the aim of securing a favorable environment for organization rewards. Thus, it is important for proper capital asset pricing model to be effectively determined and specified in order to reduce the extent through which negative values and influences are enhanced within trading firms (Benjamin, 1966).
The fundamental of market efficiency is explained by the appropriate response that information brings about, and the effect that the response has on security prices. This is an aspect that tends to explain the fundamental values that prices conform to, with the aim of addressing the possible situation where assets are over-valued and sometimes undervalued based on the prices that are imposed on the assets over a period of time. According to Dimson and Mussavian, (1998, pg 97), the fluctuations in the stock market prices vary based on payments provided in terms of dividend. Contrary to the random walk model, the security returns can be evaluated based on the time horizons and prices can effectively be determined. Accounting in firms using the form of short term returns require more costs in enhancing price predictability for the short term strategy.
In the real world, it is clear that some investors get to lose and others gain from the trading. Trading is like a game that the players have to focus on in order to ensure that they beat the market and win. Information is an important factor that facilitates the winning and losing process in trading, but there are various challenges associated with the acquisition of investment information. In some instances, information is costly, and the cost may have an effect on the decisions that investors make in relation to trading. Some of the investors may make decisions without clear information, and this calls for a better interpretation of the trading information in order to establish positive returns with minimum risks. When this is achieved, the market becomes efficient, as the market prices are effectively determined.
Market efficiency is a theory that seeks to secure information used in reflecting the financial asset prices. Literature on the study has provided information on the features of market efficiency, and the random walk model and three levels of efficiency hypotheses have been developed to explain the history and development of the theory. Random walk model explains the history of market efficiency in terms of financial changes in prices. Financial asset prices fluctuate randomly making it difficult for the economics to predict future market prices. The study of price change provides the economists with an opportunity to predict future stock prices in the market (Banz, 1981, pg 16). The three levels of efficiency hypotheses provide information on the development of the theory in seeking to establish efficiency. The concept of efficiency is well explained by the formation of prices in the markets that are more competitive where buyers get sellers for transactions to take place. Event studies addresses the aspect of stock performance taking into consideration the time taken to measure the stocks and enhance market adjustments. The hypothesis provides an opportunity for the market situation to be evaluated and understood. The strong form efficiency that enhances identification of more information that is essential in creating profits. CAPM and market models are used to enhance price adjustments to prices and earnings (Fama, 1970, pg 388).
The model has been effective especially in the 21st century as it has been able to address anomalies associated with establishment of market efficient. Anomalies may be the results of poor testing of market efficiency hypotheses that offer bad specifications for the pricing model. This call for proper understanding of the pricing model to avoid making mistakes that may affect the market in terms of price formation and return adjustments. Information is essential for investors, and lack of that information may bring uncertainties increasing the risks associated with the investment process. The random walk of stock returns and prices show the variation of portfolio returns that differ temporarily in different months. The size of the firm has a different impact on market efficiency. Large firms are always ahead of the smaller firms in terms of performances in the trading environment (Keim, 1982, pg 31). In enhancing market efficiency, it is important to consider positive values that are associated with positive returns on the earning price ratio determination. To enhance positive feedback in trading, certain price behaviors are observed where market adjustments are done thus enhancing positive returns. Thus, it is important for investors to consider the use of information as their essential element in making decisions to enhance market efficiency.
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