Q1. What is EMH? Discuss in detail the evidence for and against?

“A market that adjusts rapidly to new information.”

When market is fully passing out the correct or the exact information and the stock prices are exactly according to their intrinsic value, state by the theory “Efficient Market Hypothesis”. This theory tells that at any given time, security prices fully reflect all available information. The implications of the efficient market hypothesis are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

It says that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Evidence ‘for’ EMH

Random walk behavior of the stock prices

The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements. An important implication of the efficient market hypothesis is that stock prices should approximately follow a random walk; that is, future changes in stock prices should, for all practical purposes, be unpredictable.

Stock prices reflect publically related information

The price of the stocks fully reflects the information which public gathers from the trend in the market and thus the market price of the stocks are exactly according to the intrinsic or the par value of the stocks. Which ensure that the investor cannot get abnormal profits over trading in the stocks.

Performance of investment analysts and mutual funds

Financial analysts who are specialized in the investment sector have seen in the past that they randomly failed to beat the market. We have seen that one implication of the efficient market hypothesis is that when purchasing a security, you cannot expect to earn an abnormally high return, a return greater than the equilibrium return. This implies that it is impossible to beat the market. Many studies shed light on whether investment advisers and mutual funds beat the market. One common test that has been performed is to take buy and sell recommendations from a group of advisers or mutual funds and compare the performance of the resulting selection of stocks with the market as a whole. At the end, the failed to do so and their observations are mostly not according to the market trend.

Mutual funds also do not beat the market. Not only do mutual funds not outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period do not beat the market in the second period. The conclusion from the study of investment advisers and mutual fund performance is this: Having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future.

Technical Analysis

A popular technique used to predict stock prices, called technical analysis, is to study past stock price data and search for patterns such as trends and regular cycles. Rules for when to buy and sell stocks are then established on the basis of the patterns that emerge. The efficient market hypothesis suggests that technical analysis is a waste of time. The simplest way to understand why is to use the random-walk result derived from the efficient market hypothesis that holds

that past stock price data cannot help predict changes.

Evidence ‘against’ EMH

Small firm Effect

One of the earliest reported anomalies in which the stock market did not appear to be efficient is called the small-firm effect. Many empirical studies have shown that small firms have earned abnormally high returns over long periods of time. Rebalancing of the portfolios by the investor could be the reason for getting the abnormal profit over specific period of time.

Or that it may be due to low liquidity of small-firm stocks, or large information costs in evaluating small firms

January Effect

Over long periods of time, stock prices have tended to experience an abnormal price rise from December to January that is predictable and hence inconsistent with random-walk behavior. This so-called January effect seems to have diminished in recent years for shares of large companies but still occurs for shares of small companies. Some financial economists argue that the January effect is due to tax issues. Investors have an incentive to sell stocks before the end of the year in December, because they can then take capital losses on their tax return and reduce their tax liability. Then when the New Year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns.

Other seasonal Effects

Holiday and turn of the month effects have been well documented over time and across countries.

Q2. What is weak, semi-strong and strong form of EMH?

There are 3 types of Efficient Market Hypothesis which are as under:

1. Weak form of Hypothesis

The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. The prices of the stocks already represents the past data related to those securities therefore it shows the exact price of that particular stock. In other words, technical analysis is of no use.

2. Semi-strong form of Hypothesis

The "Semi-strong" form asserts that all publicly available information is fully reflected in securities prices. As one can gain a profit that exceeds from their expectations if he/she gets the hidden information, because if they will come to know about any specific security, an investor will take decision according the news they got. An example could be:

Information comes out that the prices of wheat will reduce in the coming days because of the good progress and higher competition among the wheat industry, this information will make sure to the investor that they don’t purchase any more stock of the wheat sector and instead of buying more stocks they will sell the stocks to get the maximum benefit from those security because they came to know that the prices of wheat will decrease which will effect in the decrease of the stock prices to that specific item.

In other words, fundamental analysis is of no use.

3. Strong form of Hypothesis

The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use. Stronger hypothesis says that the market is very well based on the information and the price changes accordingly therefore you cannot get the maximum profits or abnormal return over the investment.

Q3. Some economist says that EMH is responsible for the global financial prices. Do you agree or disagree. Discuss?

I personally don’t agree with this statement that EMH was held responsible for the recent global financial meltdown. The answer is no. Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low. The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market. This does not mean the EMH can be used as an excuse by the CEOs of the failed

financial firms or by the regulators who did not see the risks that subprime mortgage-backed securities posed to the financial stability of the economy. 

Misunderstanding efficient markets

There is a lot of wisdom in Stephen Brown's argument that it wasn't excessive belief in efficient markets that caused the financial crisis – it was the failure to understand the efficient market hypothesis.

Many commentators have suggested that economists in general and financial economists in particular have some responsibility for the recent global financial crisis. They were blinded by an irrational faith in a discredit Efficient Markets Hypothesis and failed to see the bubble in asset prices and to give due warning of its collapse. There is considerable confusion as to what this hypothesis is and what it says. The irony is that the strong implication of this hypothesis is that nobody, no practitioner, no academic and no regulator had the ability to foresee the collapse of this most recent bubble. While few economists believe it is literally true, this hypothesis is considered a useful benchmark with some important practical implications. Indeed, a case can be made that it was the failure to believe in the essential truth of this idea which was a leading factor responsible for the global financial crisis

Our crisis wasn't due to blind faith in the Efficient Market Hypothesis. The fact that risk

premiums were low does not mean they were nonexistent and that market prices were

right. Despite the recent recession, the Great Moderation is real and our economy is

inherently more stable.

But this does not mean that risks have disappeared. To use an analogy, the fact that

automobiles today are safer than they were years ago does not mean that you can drive at

120 mph. A small bump on the road, perhaps insignificant at lower speeds, will easily flip

the best-engineered car. Our financial firms drove too fast, our central bank failed to stop

them, and the housing deflation crashed the banks and the economy.