Efficient Market Hypothesis

EFB201 Financial Markets

Analysis of the Efficient Market Hypothesis

From the Classroom to the Trading Floor – Are Markets Efficient?

Scott Vanderwolf

N7534485

Developed by Eugene Fama, the proposition of the efficient market hypothesis in its three nested iterations – weak, semi-strong and strong form - has been a contentious topic among academics and investors since inception. Bearing correlation to the random walk hypothesis of stock price movement, Fama’s theory suggests that as markets reflect all relevant information, investors cannot consistently make abnormal returns. As luminaries of the finance world, Richard Roll and Warren Buffett built their careers on their approach to investment, notably in critiquing the Capital Asset Pricing Model, and as the pre-eminent value investor of our time respectively. Consequently, their quotes may be in part self-serving, however the success of each underlines the validity of both approaches.

It is the writer’s opinion that while markets are efficient in a vacuum, and tend towards efficiency in large sample sizes, external forces, and the modern investment environment enables the slight possibility of consistent abnormal returns. This paper will critically evaluate theoretical aspects of capital markets, and significant market events to lend support to this proposition, and identify investor groups who can take advantage of inefficiency.

Empirical Testing

Weak-Form Efficiency

Characterised as a minimum threshold for market efficiency, this form suggests that abnormal returns cannot be made by analysing historical prices, rendering technical analysis redundant. Developed nations with fully integrated financial systems are considered to have greater efficiency in markets, and by extension, the lowest levels of serial correlation in returns. Technical trading strategies by nature create greater transaction costs than passive buy-hold strategy, and although evidence of positive serial correlation...