The effective market hypothesis

(ii)
Discuss the observations
(a)
Annual market returns are negatively correlated
This observation suggests that, over annual time periods, the market tends to
systematically overreact to new information and hence that the market may not be semistrong form efficient.
In addition, trading rules could be developed based on this information that could
generate excess, risk-adjusted returns, which suggests that this observation is
inconsistent with the weak form of the EMH.
(b) The index is higher on Fridays than on Mondays
The observation suggests that there is a consistent tendency for prices on Fridays to be
“inflated”, while prices on Mondays are “depressed”, ie there is a systematic bias
present in the prices.
Trading rules could be developed based on this information (eg buy on Monday, sell on
Friday) that could generate excess, risk-adjusted returns, which suggests that this
observation is inconsistent with the weak form of the EMH.
(c) Announcements take three months to be reflected
If the semi-strong form of the EMH holds, public dividend announcements should have
an immediate effect on the share prices as the market should respond quickly and
accurately to new information.
This observation suggests that the market is not semi-strong form efficient.
(d) Prices fall following a favourable announcement
The prices are reacting when information is made public. This suggests that the prices
have previously been distorted by insider information.
Therefore, this observation contradicts the strong form of the EMH.
Note that, once a particular form of the EMH is contradicted, this also contradicts any
of the stronger forms.

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The Efficient Markets Hypothesis (EMH) suggests that it is not possible to achieve
excess risk-adjusted investment returns using investment strategies based only on
certain subsets of information. The existence of fund managers who sell their services
based on their alleged ability to select over-performing sectors and stocks does not
demonstrate that capital markets are inefficient.
In particular, the semi-strong form of the EMH suggests that excess risk-adjusted
investment returns cannot be obtained using only publicly available information.
In certain investment markets, it may therefore be possible (and legal) to achieve excess
returns using privileged or inside information, which fact would not contradict the semistrong form of the EMH.
More generally, the EMH does not preclude managers achieving higher investment
returns by adopting “riskier” investment strategies and receiving due reward for the
risks taken. It says precisely that it is not possible to develop investment strategies that
yield excess risk-adjusted returns – though it is difficult to determine exactly how risk
should be interpreted in this context.
Some fund managers must necessarily achieve higher than average returns over a given
short time period – eg several years. The point of the EMH is that managers cannot
consistently achieve above excess returns. Moreover, they cannot guarantee to achieve
excess returns over any particular time period.
Finally, rather than reflecting any market inefficiency in contradiction of the EMH, the
existence of such managers may instead reflect the following facts:
● individual investors may be unaware of the EMH or choose not believe it and
hence may be inclined to believe the claims of such managers and so place
money with them.
● certain individual investors may choose to believe the claims of such managers,
reflecting the fact that investment decisions are often made on the basis of
subjective and emotional factors, in addition to, or instead of on the basis of
financial theory.
For the above reasons, the existence of such fund managers does not therefore
demonstrate that capital markets are inefficient.

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Publicly available information is a subset of all information, whether publicly available
or not. Consequently strong form efficiency implies semi-strong form efficiency, in the
sense that if a market is strong form efficient, then it must also be semi-strong form
efficient.
Similarly as historical price data is a subset of all publicly available information, so a
market that is semi-strong form efficient must also be weak form efficient.

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Such rules would be unnecessary because it would not be possible for senior
management to use this information to obtain higher investment returns by trading in
the stock of their own company. Thus, senior management would not be at an
advantage compared to other investors, who would correspondingly not be
disadvantaged by such trades.

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According to the Efficient Markets Hypothesis, active investment management cannot
be justified because it is impossible to exploit the mispricing of securities in order to
generate higher expected returns. Even if price anomalies exist, then the costs of
identifying them and then trading will outweigh the benefits arising from the additional
investment returns.

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If the market is strong form efficient, then there will be no advantage from insider
trading because all the insider knowledge should be reflected in the current share price.

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If the numbers drawn are truly random, then the market for lottery tickets is weak form
efficient, as knowledge of the numbers that have been drawn in the past will not help
you to predict the numbers that are likely to be drawn in the future, and thereby generate
excess returns. It will also be semi-strong and strong form efficient, unless it is
operated fraudulently

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Although Company A’s shares have recently yielded more than Company B’s shares,
this does not contradict the Efficient Markets Hypothesis (EMH). This is because the
EMH implies that it is not possible to identify shares that offer excess risk-adjusted
expected returns. This is different from the situation described, which refers to actual
past returns with no allowance being made for the relative riskiness of the two shares
involved. Thus Company A may be inherently more risky than Company B. Even if it
isn’t, then it may not have been possible to predict Company A’s success in advance.

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