INTRODUCTION
Financial markets are vital in a country's economy, they act as "wealth treasurers" and provide "wealth accumulation" (Milieska 2004:1). Many companies raise debt or equity for their operation and expansion, investors invest their funds in the markets and economists use the information of the markets to forecast future economic developments.
One of the main areas of financial literature is the concept of market efficiency which has attracted various economists, scientists and academicians. The basis of the concept of market efficiency is how to determine the behavior of securities price.
This idea has been started at the beginning of 20th century by Bachelier (1900) who consider that "past, present and even discounted future events are reflected in market price but often show no apparent relation to price change" (cited in Khaled and Marwan 2010:180). In the early 1950s, researchers use computers in order to examine the trend of "long-term" and "short-term" prices movements.
The finance literature concentrates three types of efficiency relevant to behavior of securities price.
Firstly, the "allocational efficiency" refers to the optimum allocation of financial resources in the economy which lead to economic development. It requires equal "risk-adjusted rates of return across all securities" which means that securities with the same risk have the same expected returns (Hall and Urga 2002:4).
Secondly, the "operation efficiency" measures the transaction costs in "a competitive way" in order to operate in the markets (Milieska 2004:7).
Thirdly, in an "informational efficiency" market, there is an "equilibrium level" which the securities are priced and all available information, which relates with the future performance and profitability of a company, must be immediately reflected in the securities price (Seyyed et al 2010:51).
During the last decades, many empirical studies have been conducted to examine the efficiency of the stock market, the bond market, the foreign exchange market and recently of derivative markets. As a result, the financial community divided into two groups, the supporters and the opponents of the efficient market hypothesis. REFERENCE
This assignment introduces the market efficiency hypothesis and focuses exclusively on the informational efficiency concern. It also represents many empirical studies which examine the efficiency of stock market and explore some anomalies from where investors can earn abnormal return.
Efficient Market Hypothesis
Eugene Fama (1970:383) defined the efficient market hypothesis (EMH) that "security prices at any time fully reflect all available information". In other words EMH studies the reaction of the prices to the new information.
Pilbeam (2010:238) suggests that there are two main concerns of EMH: how quickly and correctly the new information adjusts in the shares price and what is "relevant" and "irrelevant" information? In other words, market efficiency refers to the time, the speed and the accuracy of the market to react to the new information and the ability to figure relevant information. According to the EMH the more of these dimensions we have the more efficiency is the market.
Moreover, Fama (1970) classified the market efficiency into three different levels depending on the informational efficiency: weak form efficiency, semi-strong form efficiency and strong form efficiency.
Versions of efficient market efficiency
Weak form Efficiency is the "lowest level of efficiency" (Lumby and Jones 2003:357). It states that the current prices of the securities fully reflect all information of the history of past prices and trading volume. If the market is weak form efficiency, it is impossible to predict new securities movement and identify "mispriced securities" by looking and analyzing their historical price movement (Lumby and Jones 2003:357).
Semi-strong form Efficiency states that the current prices of securities adjust immediately all "publicly available information" (Pilbeam 2010:238). Publicly information includes not only the historical prices but also includes financial statements of a firm, earning forecast, stock splits and other announcements by the firm (Bodie et al 2009). If the market is semi-strong form efficiency, it is impossible to outperform the market and earn abnormal returns by studying publicly available information. However, according to Barnes (2009:46), in this level of efficiency those who have access of "inside information" and trade on that can earn excess return which is illegal.
Neither fundamental analysis which studies past earnings and financial statements of companies nor technical analysis which studies movement of past prices will be able to produce abnormal return and make profit in markets of this level of efficiency (Khaled and Marwan 2010).
Strong form Efficiency is the most extreme form. It implies that the current prices of securities reflect all information, publicly and "private" information (Pilbeam 2010:238). Private information refers to the information which is available only for people who are inside the company. (Bodie et al 2009). If the market is strong efficiency form efficiency, it is impossible to achieve an excess return by using this kind of information because the security price reacts so fast to both public and private information (Pilbeam 2010).
Information and market efficiency
The concept of the efficient markets depends on the "precise definition of information" (Akintoye 2008:7). The disclosure of information is an important requirement for stock markets in order to operate efficiency and to reduce the probability of asymmetric information.
"Information asymmetric is absent in an efficient market" (Somoye et al 2008:10). Brown & Hillegeist (2003) argue that, it is obvious that asymmetric information can occur only in semi-strong and weak form of efficient market when some investors know additional information while others know only the publicly information (cited in Somoye et al 2008).
The quality of information is a major aspect of market efficiency. Investors can take financial information or non-financial information about a company from many resources such as financial statements and reports which are very useful and provide specific information for investors in stock market. (Tzung-Yuan et al 2010).
Rational expectations
Moreover, according to Hartman and Rodestedt (2010:2), the EMH assumes that each individual in the market has "rational expectations". Different individuals recognize the new information, evaluate it and make their decision to buy or sell shares in different ways according to their preferences. Moreover, because some investors are more risky or more optimistic than others they have different expectations to make profit.
CAPM
Nicolay (2009:7) argues that some assumptions of the EMH are the same with some assumptions of the "asset pricing models". For example, the no "transaction cost", "rational" investors and "information homogeneity" are included in the CAPM. According to Somoye et al (2008:11),"CAPM is designed for a perfect market" without asymmetric information. When the market is inefficient, analysts cannot use it correctly in order to define the relationship between the systematic risk and the expected return of a stock price.
Empirical Approaches of EMH
In the theory, the efficient market hypothesis should be a "powerful tool" which analyses the behavior of prices in the markets. (Frederic and Stanley, 2009:127) However, it is necessary to "compare the theory with the data" in order to examine in the reality that EMH is also a useful tool.
The concept of market efficiency has been the main subject in many empirical tests of corporate finance. According to Lumby and Jones (2003:360), this occurs because an observation of inefficiencies in the market, it might provide someone with "opportunities for substantial financial gains". The empirical work divides to three categories depending on the information efficiency.
Weak form tests
In 1953, Kendall used "economic time-series" in order to examine if the prices base in past information. (cited in Hartman and Rodestedt 2010:8). He supports that the prices appears to follow a random walk and conclude that investors can not earn abnormal return by studying historical stock prices. Fama (1965) leaded to the same conclusion as Kendal by using "serial correlation coefficients and different time period" (cited in Hartman and Rodestedt 2010:10).
Many empirical tests have been conducted for the weak form of efficiency in order to show that the stock prices tend to follow "random walk process".
According to Barnes (2009:45), random walk theory asserts that "the movement of stocks the one day is not correlated with the price change the following day". Seyyed et al (2010:52) argue that because the new information arrives in a random way, the movements of the future stock prices should be random and cannot be predicted. As a result, they suggest that the weak form of efficiency is "compatible" with the random walk theory.
According to Pilbeam (2010:242-243), most of the academic studies support that the stock prices follow "a random walk or random walk with positive drift component" and that daily, weekly and monthly data of the trend of prices are "largely random". Moreover, it is difficult for the investors to predict future prices by using historical movement of prices or any information on past prices. He argues that there is 50% probability the stock price to increase and 50% to decrease and he supports that the price today is the best forecast for investors in order to predict the price tomorrow or the future price. EQUATION
According to Seyyed (2008), in the recent years, many research papers examine the stock markets of many countries and conclude that for some of them their stock prices follow random walk and are weak form of efficiency for a specific period of years. On the other hand, some others empirical tests reject the weak form of efficiency.
The majority of studies agree that the use of past prices cannot be useful to predict future prices. However, some findings which are often refer as efficient market anomalies show that there is a possibility to find someone's information which might give him the opportunity to produce abnormal return.
The day-of-the week effect
Cross (1973) and Gibbons and Hess (1981) have concluded that the share prices seems to fall on Monday and rise on Friday (cited in Pilbeam 2010). This effect is opposite to the weak form of efficiency. However, Connolly (1989) in his study concluded that the recent years this effect had disappeared.
The January effect
Rozeff and Kinney (1976) has found the January effect that the stocks seem to have "systematically higher returns" than other months of the year (cited in Moller and Zilc 2008:447).Moreover, Keim (1983) find that the most important effect is that the small companies seem to "outperform the market" in January (cited in Pilbeam 2010:243).
In the study of Moller and Zilca (2008:448) exist the January effect and they give two explanations for this. Firstly, investors sell their losing shares to reduce the taxes in the end of every year and when they buy them again in January the price raise. Secondly is the "window dressing". Fund managers in order to make their portfolio most acceptable to fund holders in the end of the year reports, sell the small companies stocks in December and buy them back in January because these companies are riskier investment and managers expect higher returns.
Semi-strong tests
Semi-strong form tests focus on the impact of publicly information such as stock split, bonus issues, earnings, dividends, right issues, mergers and acquisitions, on the stock market and especially the speed of price adjustment during the days, before and after the announcement (Mehndiratta and Gupta 2010).
According to Barnes (2009:46), these studies compare the "expected return" for a sample of stock shares, which would be expected by using a model such as CAPM, with their "actual return". The difference between the expected and actual return is the abnormal return.
There are various studies which examine the influence of different type of announcement and the majority of them support the semi-strong form of efficiency.
One of the earliest studies and example of semi-strong form efficiency presented by Fama et al (1969) in their paper "The adjustment of stock prices to new information". They examined the reaction of the share prices to the announcement of a stock split by looking at abnormal returns on the shares of some companies, 30 months before and after the stock split day.
Figure 1 shows the results of their study. It seems that in the 30 months prior to the stock spit announcement the shares gave "a strong positive abnormal return" and after this day there was no significant movement in the share return (Lumby and Jones 2003:362).Moreover, Fama et al (1969) examined the effect of stock split on the future dividend payment by dividing their sample in the companies which increased or did not increase their dividends at the day of the stock split. Figure 2, 3 show their results. Companies which increased their dividends, they had an increase in the stock price and maintained this level. On the other hand, companies which did not increase the dividends had a fall in the price because the expectation of inventors did not occur. These results support that the market is efficiency because the stock price fully reflect and adjust rapidly the announcement of stock split.
Patell and Wolfson (1984) examine 571 earnings and dividend disclosure and find that the "trading profits" disappear within 5 to 10 minutes after the announcement (cited in Hartman and Rodestedt 2010). Malkier (1989) argue that the market reflect public information within 5 to 15 minutes after the announcement (cited in Garsia de Andoain and Bacon, 2009). This supports that investors cannot earn abnormal return by using public information and the market is semi-strong form efficiency.
Tzung-Yuanet et al (2010:136) examined the association between "financial reporting quality" and speed of price adjustment in Taiwanese stock market. They found that the speed of the prices for the good news is faster than the bad news. They also found that the information quality not affects significantly the speed of price adjustment but they have positive relationship.
However, some researches shows that like weak form there are some anomalies of semi-strong efficiency and investors can earn abnormal return by using publicly information.
The firm size effect
The firm size effect documented by Banz(1981) who find that stock of smallest companies had higher annual returns between 1926-2006 and that the beta of the firms can explain this result (cited in Pilbeam 2010). As Bodie (2009:363) explains small firm are riskier as measures by their betas, as a result, "when returns are adjusted for risk using the CAPM", there is a greater volatility of returns for these firms.
The earning-announcement effect
Rendleaman et al (1982) examine the reaction of stock prices of a large sample of firms (cited in Bodie 2009).They divided the firms in 10 groups according to the level of good or bad news of their earnings announcement. The most interesting observation was that investors could earn excess profit 90 days after the announcement date. The markets seems to "adjust the earning information gradually, resulting a sustained period of abnormal returns" and not immediately at the time of the announcement as they expected from the semi-strong form of efficiency (Bodie 2009:365).
This anomaly documented firstly by Ball and Brown (1968) who estimate firms which had expected good or bad earning and examine the share changes 12 months prior and 6 months after the earnings announcement day. (cited by Barnes 2009) FIGURE BUBBLES
Strong form tests
Strong form of efficiency "requires knowledge of inside information" in order to test someone the reaction of stock prices and this reason is difficult to be tested by the researchers (Lumby and Jones 200:364). Moreover, according to Pilbeam (2010:253), after the law against the inside information it is difficult to market price to reflect this information before it is made public.
Maloney and Mulherin (2002) examined the stock reaction of the four firms which linked with the Challenger crash. On the day of the crash the market responded quickly and accurate to new information by declining the firms' prices and from the trading of the stocks seemed clear which of the firm was responsible. The information of the reason of this disaster seems that was private information because the price market did not have any effect before the day of the crash. It could be said that this study supports the strong form of efficiency.
Other factors which affect the market efficiency
Liquidity: Chordia et al (2008:249) argue that "short horizon return from order flows is an inverse indicator of market efficiency". They examine large NYSE firms and Chung and Hrazdil (2010) extend this study for all NYSE firms and in a different study examine a sample of 11073 NASDAQ firms. All the studies conclude to the same results that an increase in liquidity enforces market efficiency. Prices reflect effectively new information during more "liquidity regimes" and liquidity has positive relationship with market efficiency. Higher liquidity favors "arbitrage activity" which causes lower return predictability and higher market efficiency (Chung and Hrazdil 2010:2348)
Market Structure: Masulis and Shivakumar (2002) explore that the market structure affect the reaction speed of stock prices to new information. They compare their results from Nasdaq, NYSE and AMEX (American stock exchange) markets which all of them are competitors in the U.S. and have different "organization structures, economic, legal and regulatory environment" (Masulis and Shivakumar 2002:618). They found that "Nasdaq has faster electronic execution system, greater quote depth and dealer risk bearing, along with the threat of SOES bandits and stale NYSE/AMEX limit orders, all contribute to Nasdaq's faster price adjustment to news".
Macro-economies news: Funke and Matsuda (2006) provide that for USA, macroeconomic news such as GDP growth, risk-free interest rate and unemployment affect the stock prices. If these news are bad or good news for stocks depends on the "state of the economy" (Funke and Matsuda 2006:208). Moreover, they present evidence which indicates that foreign news have impact of the stock prices both for USA and Germany. Finally, they argue that not only macroeconomic news but political news have significant effect on stock prices.
Liberalization: According to Kawakatsu and Morey (1997:385) the EMH support that when stock market are liberalized, "stock market should reflect the increased availability of information and be more efficiency". Kim and Singal (2000:45) examined a sample of twenty countries and observed an improvement in market efficiency after the liberalization and the opening of stock markets to the public. They observed "decrease in predictability" over longer periods and that in general the stock returns become more random after liberalization.
Conclusion
The majority of empirical studies support the EMH. However, no theory is perfect. If the market was efficient, there will not be anomalies and abnormal return opportunities for the investors. As it has already been described above, some studies which looking information variables could prove and find abnormal return opportunities and anomalies. These anomalies indicate that may be some past price information are useful and could be use and produce abnormal profit opportunities.
Behavior Finance is a growing area of research and tries to explain some features of stock markets behavior that are not well explained by the efficient market hypothesis. This field of behavior finance studies the psychology of investors which it could be said that maybe create some of the anomalies of efficient markets that they have been mentioned above or other divergence from the EMH. Until now, studies of psychologists show that loss aversion, overconfidence and social contagion explain the high level of trading of the securities, the overvaluation of stock prices and why bubbles occur. (Frederic and Stanley 2009)
The EMH continues to be the best description of price behavior in the stock markets.Therefore, it is obvious that future work is essential in a broad range of areas like behavior finance in order to explain better the inefficiencies of the markets and examine the degree of which security analysis improve investment performance. The argument of Nicolay (2009) that pricing models must be developed which will take into account the inefficiencies are represented by the empirical studies seems to be a "worthwhile agenda" for future research.
