What is an Efficient Market?

An efficient market is a capital market where the current market price of an asset can adequately reflect all relevant and available information. Including weak effective market, semi-strong effective market and strong effective market in three forms. It was originally proposed by French mathematician Bachelier in the early 20th century. In 1970, American financial scientist Fama deepened and proposed the "efficient market hypothesis." It is believed that under the assumption of an efficient market, stock prices can fully reflect all information, so unreasonable prices will be eliminated soon. Under this assumption, any investment that relies on information cannot produce excess returns. The capital market is a completely competitive market, and each participant is a price receiver. Therefore, the price of the capital market can provide a basis for corporate investment and financing decisions. The efficient market hypothesis is one of the important theoretical cornerstones of modern corporate finance. ^[1]

Efficient market

An efficient market is a capital market where the current market price of an asset can adequately reflect all relevant and available information. Including weak effective market, semi-strong effective market and strong effective market in three forms. It was originally proposed by French mathematician Bachelier in the early 20th century. In 1970, American financial scientist Fama deepened and proposed the "efficient market hypothesis." It is believed that under the assumption of an efficient market, stock prices can fully reflect all information, so unreasonable prices will be eliminated soon. Under this assumption, any investment that relies on information cannot produce excess returns. The capital market is a completely competitive market, and each participant is a price receiver. Therefore, the price of the capital market can provide a basis for corporate investment and financing decisions. The efficient market hypothesis is one of the important theoretical cornerstones of modern corporate finance. ^[1]

An efficient market is a market in which all information is quickly understood by market participants and immediately reflected in market prices. This theory assumes that investors participating in the market are sufficiently rational to respond quickly and reasonably to all market information. The efficient market hypothesis assumes that in a society full of information exchange and information competition, a specific piece of information can be quickly known to investors in the stock market. Subsequently, the competition in the stock market will drive the stock price to fully and timely reflect the group of information, so that the transactions performed by the group of information do not have abnormal returns, and can only earn a risk-adjusted average.

According to the types of information available to investors, Fama divides efficient markets into three levels: Weak-Form EMH, Semi-Strong-Form EMH, and Strong-Form EMH -Form EMH).

The assumption of market effectiveness is based on a perfect market:

(1) There is no friction in the entire market, that is, there are no transaction costs and taxes; all assets are fully divisible and tradable; there are no restrictions.

(2) The entire market is fully competitive, and all market participants are price takers.

(3) The cost of information is zero.

(4) All market participants receive information at the same time. All market participants are rational and seek to maximize utility.

In real life, these assumptions are difficult to hold. Investors must consider the following costs when investing:

(1)

The "perfect market" premise will make the market non-existent

1. The hypothesis of market effectiveness is based on a perfect market, but the premise of a "perfect market" will make the market impossible.

Think about it, what is zero information cost? The cost of information obtained without paying is zero, but the information obtained by physical possession does not participate in decision-making (such as an illiterate getting a free newspaper). If you consider the time and effort required for decision-making, assuming that the cost of information is zero, you are assuming that learning does not require time and effort, and that decision-making does not require time and effort. Everyone is independent of age, gender, occupation, and intellectual status. All other differences have the same ability to obtain and understand information (a child understands everything when he is born), no matter how ridiculous this assumption is, let s assume that this happens. All people have the same level of intelligence and the same The ability to analyze and interpret information is the same. Everyone makes the same rational decision based on the complete information set.

So-who trades with whom? Since everyone has the same interpretation of the information, their behavior is the same, they all have to buy or sell, who will act as the opponent? Are there any transactions? Will there still be a market?

Based on the prerequisites of an effective market, the market will not exist.

Market prices reflect everything

2. Market prices reflect everything, not just all available information, but also unknowns

according to

EMH 's theoretical challenges

(1) Investors are not completely rational. Fischer and Black (1986) point out that investors buy on the basis of "noise" rather than information. Noise is information noise, which refers to information disclosed on the market that cannot reflect the true situation.

(2) Investors not only stray from reason by accident, but often from the same way. The "investor mindset" theory in behavioral finance discusses the fact that a large number of investors make the same mistakes in judgment, and their errors are related.

(3) Arbitrageurs will not completely eliminate the impact of irrational investors' errors on prices. In most cases there is no suitable substitute for securities. Even if a complete alternative can be found, arbitrageurs face other risks, such as the noise trade riskunpredictable prices in the future

Empirical challenges facing EMH

I. Challenges to weak efficient markets

(1) De Bondt and Thaler (1985) found a long-term reversal effect.

(2) Jegadeesh and Titman (1993) found the "momentum effect".

(3) January effect

Challenges to Semi-Strong Effective Markets

(1) Small-scale effect, p / e effect, pb effect.

(2) Overreaction anomalies: IPOs-Ritter (1991), Loughran & Ritter (1995); SEOs-Loughran & Ritter (1995), Spiess & Affeck-Graves (1995); New exchanges listings-Dharan & Ikenberry (1995).

(3) Insufficient response vision: Post-announcement Drift-Ball & Brown (1968), Bernard & Thomas (1990); Spinoffs-Cusatis et al. (1993); Stock splits-Desai & Jain (1997), Ikenberry et al. (1996); Share tenders-Vermaelen (1990); Open-market share repurchases-Ikenberry et al. (1995); Dividend omissions and initiations-Michaely et al. (1995).

(4) Unable to distinguish between overreaction and underreaction: Mergers (acquring firm)-Asquith (1983), Agrawal et al. (1992); Proxy contests-Ikenberry & Lakonishok (1993).

3. The challenge of no response to news vacuum but stock price:

(1) Cutler et al (1991) The stock prices of the 50 companies with the largest fluctuations in the US stock market on the day after the war. Many did not change significantly.

(2) Two studies by Roll (1994, 1998) show that it is the unexpected shock rather than the news that causes stock price volatility.