In Light of Existing Evidence, Critically Analyse the Validity of the Strong-Form of the Efficient Market Hypothesis

MN2117

Stock Market Analysis and Equity Valuation Assignment

10th May 2010

Student ID: 080222631

Topic 2: In light of the existing evidence, critically analyse the validity of the strong-form of the Efficient Market Hypothesis

Introduction

The Efficient Market Hypothesis (EMH) is a term which was first used by Eugene Fama in 1970, stating that for a market to be efficient, it must ‘“fully reflect” all available information’ [Fama 1970:383]. In addition to this, he described three types of the EMH expressing three different levels of information reflected in market prices. The Weak-form of the EMH suggests that market prices are solely based on the ‘history of past trading,’[Bodie et al. 2008:231] which is publicly available; the semistrong-form implies that market prices are based on all publicly available information and the strong-form suggests that all relevant information is immediately reflected in stock prices, including insider information. By considering a market where all information is fully reflected in the prices, Fama contemplates a set of conditions that would have to be in place for capital market efficiency: ‘(i) there are no transaction costs in trading securities, (ii) all available information is costlessly available to all market participants, and (iii) all agree on the implications of current information for the current price and distributions of future prices of each security,’ [Fama 1970:387]. Fama does go on to say that even though these conditions are not necessary and not always descriptive of reality, they are ‘best viewed as a benchmark against which the importance of deviations from market efficiency can be judged’ [Fama 1970:414]. Based on the strong-form EMH, no one should be able to consistently earn positive abnormal returns. This paper is going to look into the research that has gone into analysing the strong-form EMH in order to evaluate its validity, by looking at the following investor classes: Corporate Insiders;...