Efficient Market Hypothesis Essay Example | Topics and Well Written Essays - 2500 words

Efficient Market Hypothesis - Essay Example Importance of efficient market hypothesis can be identified from empirical implications of it in many pieces of research and studies by empirical researchers. Literature on efficient market hypothesis before LeRoy (1973) and Lucas (1978) was evolved around the random walk hypothesis and magnitude model. These are statistical description of price changes that can be Lo and McKinley (1988) forecasted and initially taken to be implication efficient market hypothesis. The first test of random walk hypothesis was developed by Jones and Cowles (1973), and they compared frequency sequence and reversal in historical return of stocks. They identified same sign of former pairs of consecutive return and the opposite sign of latter pair of consecutive return. Osborne (1959), Fama (1963; 1965), Cootner (1962; 1964), Fama and Blume (1966) conducted tests of random walk hypothesis and supported previous studies of random walk hypothesis using historical stock return. Lo and McKinley (1988) reported that variance of two week stock return is double the variance of one week stock return. They conducted this test on US indexes from 1962 to 1985. French and Roll (1985) identified from their study that variance of stock return over weekends and holidays are much lower than variance of week days, especially first three weekdays of a week. Poterba and Summers (1988) and Fama and French (1988) found out negative correlation in US stocks indexes return from stock return data of 1962 to 1986 actually occurs.... In the process they use different forecasting techniques as well as some valuation methods. The combination of the techniques helps them in their decisions regarding investments. However, the hypothesis states that the techniques are not effective and no one has the capability to predict the outperformance of the market. If the investors enjoy any advantage, it is supposed not to exceed the incurred cost of transaction and research (Timmermann, & Granger, 2003, p.5). Literature review The origin of efficient market hypothesis can be traced back in the studies of two individuals in 1950s. One is Paul A. Samuelson and the other one is Eugene F. Fama. They identified the notion of market efficiency from two different research agendas. Samuelsson’s contribution in the invention of EMH was great, and the researcher summarized that in efficient market, changes in asset (stocks, bonds and other traded instruments) price can be forecasted if these are properly anticipated. This means price should fully incorporate all the information and expectation of all the market participants. In contrast to Samuelsson, Fama concentrated on statistical measures of stock price and resolving the debate regarding technical analysis and fundamental analysis of stock price. This researcher summarized that current price stocks fully reflect all information available to market participants. These two empirical research studies on this critical area of finance have helped many researchers thereafter to develop several econometric single or multifactor linear asset pricing models (Seweel, 2011, p.4). Random walk hypothesis Importance of efficient market hypothesis can be identified from empirical implications of it in many pieces of research and studies by empirical researchers.