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Efficient Capital Market Theory in Security Analysis

The theory is familiarly known as “Efficient Capital Market Hypothesis: (ECMH). It is based on the assumption that in efficient capital markets prices of traded securities always fully reflect all publicly available information concerning those securities. For market efficiency there are three essential conditions:

  1. All available information is cost free to all market participants,
  2. No transaction costs, and
  3. All investors similarly view the implications of available information on current prices and distribution of future prices of each security.

It has been empirically proved that stock prices behave randomly under the above conditions. These conditions have been rendered unrealistic in the light of the actual experience because there is not only transaction cost involved but brokers have their own information base made available by processing compute fed date. Moreover, information is not cost less and all investors do not take similar views.

Categories of Efficient Capital Market Hypothesis

Research studies devoted to test the ECMH are put into three categories i.e.

  1. the week form theory,
  2. the semi-strong form, and
  3. the strong form.

1. The Weak Form theory:

This theory states that current security prices fully reflect information available in the market regarding historical events of the company Study of the historical sequence of prices, can neither assist the investment analysts or investors to abnormally enhance their investment neither return nor improve their ability to select stocks.

It means that knowledge of past patterns of stock prices does not aid investors to make a better choice. Random Walk Theory is the offshoot of this test. The theory states that stock prices exhibit a random behavior.

Random walk Hypothesis; The Hypothesis presupposes that stock prices move randomly. No sure prediction can be made of future movement of stock prices on the basis of given prices at the end of one period. There is no relationship between today’s price and tomorrow’s price. Price movement is a random. The various statistical tests conducted in U.K. and U.S.A. on stock price have proved that the “extent of dependence between Successive price changes is negligible”.

2. Semi-strong form of Efficient Market Hypothesis:

This hypothesis holds that security prices adjust rapidly to all publicly available information such as functional statements and reports and investment advisory reports, etc. All publicly available information, whether good or bad is fully reflected in security prices. The buyers and sellers will raise the price as soon as a favorable price of information is made available to the public; opposite will happen in case of unfavorable piece of information.

The reaction is almost instantaneous, thus, printing to the greater efficiency of securities market. It is to be noted that the semi-strong form of efficient market hypothesis includes that week form of efficient market hypothesis also because internal market information is a part of all publicly available information.

3. The Strong Form test of the inside information and the Efficiency of the Market:

This test is concerned with whether two sets of individuals – one having inside information about the company and the other uninformed could generate random effect in price movements. The strong form holds that the prices reflect all information that is known. It contemplates that even the corporate officials cannot, benefit from the inside information of the company.

The market is not only efficient but also perfect. It is to be noted that it includes both the weak form and semi-strong form of efficient market hypothesis. The findings are that very few and negligible people are in such a privileged position to have inside information and may make above-average gains but they do not affect the normal functioning of the market.

Efficient Market Hypothesis has put to challenge the fundamental and a technical analyst to the extent that random walk model is valid description of reality and the work of charists is of no real significance is stock price analysis. In practice, it has been observed that markets are not fully efficient in the semi-strong or strong sense.

Inefficiencies and imperfections of certain kinds have been observed in the studies conducted so far to test the efficiency of the market. Thus, the scope of earning higher returns exists by using original, unconventional and innovative techniques of analysis. Also, the availability of inside information and its rational interpretation can lead to strategies for deriving superior returns.