Discussion-Risk and Return nts ations The Efficient Markets Hypothesis (EMH) hol
ID: 1174702 • Letter: D
Question
Discussion-Risk and Return nts ations The Efficient Markets Hypothesis (EMH) holds that stocks are always in equilibrium and that it is impossible for an investor to consistently "beat the market." The weak-form of the EMH states that all information contained in past price movements is fully reflected in current market prices. 365 The semistrong-form of the EMH states that current market prices reflect all publicly available information. If this is true, no abnormal returns can be gained by analyzing stocks. Another implication of semistrong-form efficiency is that whenever information is released to the public, stock prices will respond only if the information is different from what had been expected. ng The strong-form of the EMH states that current market prices reflect all pertinent information, whether publicly available or privately held (inside information). If this form holds, even insiders would find it impossible to earn abnormal returns in the stock market In general, stocks are neither overvalued nor undervalued-they are fairly priced and in equilibrium Empirical tests have shown that the EMH is, in its weak and semistrong forms, reasonably valid. Start Discussion on Effecient Market Hypot Instructions . Discussion prompt, resource or idea/example Discussion prompt, resource or idea/exampExplanation / Answer
Answer: -
EMH (Efficient Market Hypothesis) in general states that stocks (stock exchange scrips) are neither overvalued or undervalued, they are fairly priced and in equilibrium.
Equilibrium of stock prices is arrived at the fair value of the stock that is the nature of the business, the value generated, returns on investment generated, future outlook of the scrip and the organisation capability to deliver the future outlook. Buyer and Sellers try to understand this equilibrium and arrive at stock prices of the scrip and do trading on the scrip. An information that has BUSINESS IMPACT that will contribute to enhance value of the stock or decrease the value of the stock is closely weighed by the traders and necessary trading is done as the equilibrium position may be changed by this information.
With this understanding EMH states that information contained in the past price is fully reflected in CURRENT stock prices will lead to weak-form of EMH, if publicly available information is reflected in CURRENT stock prices then it will lead to semistrong-form of EMH whereas if past price, publicly available as well as privately available information is present in the CURRENT price then it is strong-form EMH.
The information available with the traders plays a crucial role as it changes the equilibrium position of stock price. Good Example take a scrip ANYMOUS (ANY). This scrip is Pharma Industry Scrip. Now when all the information is incorporated the stock was trading on Wednesday at $17, traders were not much trading on the scrips on Wednesday, the daily volumes reflected less interest in the scrip, this showcases weak-form of hypothesis. On Wednesday evening, post closure of exchange, a positive news was provided through media stating to have got FDA go-ahead for development of research drugs, a go-ahead that was unanticipated by company. This publicly available information took the scrip on Thursday to $32 and later closed the scrip at $26. Scrip price at $26 was the equilibrium point of the scrip as per buyers and sellers hence the scrip move from previous equilibrium position of around $17 to around $26. This showcase semistrong form of hypothesis. But few of the company insiders of ANY was aware though the company got FDA go-ahead for the research drugs but it doesn't have necessary infrastructure for development of same, company also had not done any investment on the same as it was not anticipated of receiving a go-ahead. Company would require funds to invest in this new drug development means internal cash flow cannot meet the new drug development. Hence, on Friday morning, the privately information available with certain traders started to offload their ANY scrip position. The stock in Friday morning reached to $29 and was later closed at the day at $18.7. When the privately held information was available to all traders, the stock scrip arrived at $18.7 a new equilibrium position.
Thus, information regarding FDA approval on drug development created a new equilibrium position for scrip, the information was anticipated by traders and investors to have tremendous impact to BUSINESS and cash flow of the company, hence market participants reacted with new equilibrium position of $26 for the scrip. But when the information that company doesn't have infrastructure ready for development of new drug as well as enough cash flow for funding the investment resulted in crash in stock prices to $18.7. Market Praticipants had made profit for one day but it was not possible to make profit from it on next day. Insiders if they had offloaded their scrip on Thursday at $30-$32 where lucky enough to get good value otherwise they would be still stuck with little profit.
Moving from $17 to $32 is not an abnormal return but if it had gone to $55 to $75 than it could had been abnormal returns in few days.
The example explains about EMH.