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Random Walk Theory

The document discusses the efficient market hypothesis (EMH), which states that security prices fully reflect all available public information. It describes the three forms of market efficiency - weak (reflecting past prices), semi-strong (reflecting public information), and strong (reflecting all public and private information). The implications are that markets are relatively efficient, making strategies like technical analysis and some forms of fundamental analysis unlikely to succeed.

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173 views

Random Walk Theory

The document discusses the efficient market hypothesis (EMH), which states that security prices fully reflect all available public information. It describes the three forms of market efficiency - weak (reflecting past prices), semi-strong (reflecting public information), and strong (reflecting all public and private information). The implications are that markets are relatively efficient, making strategies like technical analysis and some forms of fundamental analysis unlikely to succeed.

Uploaded by

lost
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Efficient Market Hypothesis

Random walk theory.


Defining Market Efficiency
What is an Efficient Market?

An Efficient Market (confined to


informational efficiency) is a market that
reacts quickly and relatively accurately to new
public information, which results in prices that
are correct, on average.
The Efficient Market Hypothesis

Types of Efficiency
 Operational efficiency is a measure of how
well things function in terms of speed of
execution and accuracy.
 Informational efficiency is a measure of how
quickly and accurately the market reacts to
new information.
 The efficient market hypothesis (EMH) deals
with informational efficiency.
Approaches to Security Analysis
• Fundamental Analysis:
• Fundamental Factors,
• Economy, Industry & Company (EIC)
• Forecasting Dividend & price changes

• Technical Analysis :
• Share price movements are systematic, Charts

• EMH :
• Share price movements are random, not systematic, Market
price reflects the intrinsic value
Efficient Market Hypothesis
(Random Walk Hypothesis)
• Stock prices fully reflect all available information
instantaneously and accurately.
• Stock markets are so efficient and competitive that there is instant
adjustment in stock prices either upwards or downwards.
• Price of a share approximates to intrinsic value, no under or
over valued shares
• Share price movements represent a random walk than an
orderly movement.
• Assumption that stock markets are efficient – Information
efficiency.
• The more efficient the market is, the more random and
unpredictable the market returns would be.
Market Efficiency : Requisite Conditions
For markets to operate efficiently some conditions must exist:
1. A large number of rational, profit-maximizing investors exist, who
actively participate in the market by analysing, valuing, and trading
securities.
2. The markets must be competitive, meaning no one investor can
significantly affect the price of the security through their own buying
or selling.
3. Information is costless and widely available to market participants at
the same time.
4. Information arrives randomly and therefore announcements over time
are not serially connected.
5. Investors react quickly and fully (and reasonably accurately) to the
new information, which is reflected in stock prices.
The Different Types of Efficiency
• Weak Form
• Security prices reflect all historical information.
• Semi-strong Form
• Security prices reflect all publicly available
information.
• Strong Form
• Security prices reflect all information—public and
private.
Information Sets

All information
relevant to a stock

Information set
of publicly available
information

Information
set of
past prices
Efficient Market Hypothesis (EMH)
Weak Form EMH

• The theory that security prices reflect all market data, referring to
all past price and volume trading information.
• Weak form of EMH is popularly known as Random walk
Hypothesis. This is a direct repudiation of technical Analysis.

• Implication:
• If Weak Form efficient, historical trading data will already be
reflected (discounted) in current prices and should be of no
value in predicting future price changes.
Market Efficiency
Semi-strong Form
• Security prices reflect all publicly available information.
• Publicly available information includes:
• Historical price and volume information;
• Published accounting statements and annual reports

• Assumes the weak-form set of information as well as all public


information pertinent to the security such as:
• Earnings; Dividends; Corporate investments; Management changes
• Implication:
• If semi-strong efficient, it is futile to analyse public information such as earnings
projections and financial statements in an attempt to identify underpriced or
overpriced securities.
Efficient Market Hypothesis (EMH)
Strong Form EMH

• The theory that stock prices fully reflect all information, which
includes both public and private information.

• Implications:
• Stock prices are fairly priced.
• It is not possible to use public information to identify over-
priced or under-priced stocks
• It is not possible to use insider information to identify over-
priced or under-priced stocks
• Security prices reflect all information—public and
private.
• Strong form efficiency incorporates weak and
semistrong form efficiency.
• Strong form efficiency says that anything pertinent to
the stock and known to at least one investor is already
incorporated into the security’s price.
Implications of Market Efficiency

• Empirical Evidence suggests:


• Markets reach quickly and relatively accurately to new
public information
• Market prices are correct on average

• Markets may not be perfectly efficient, but they are


relatively efficient.
Implications of Market Efficiency
Implications for Investors

1. Technical analysis is not likely to be rewarded.


2. Fundamental analysis is also unlikely to be successful at
generating abnormal profits after transactions costs, research
costs and taxes.
3. Active trading strategies are unlikely to outperform “passive”
buy-and-hold strategies
4. Investors should focus on the basics of good investing by
defining investment goals in terms of expected return and
acceptable risk levels.
Implications of Market Efficiency
Implications for Corporate Officers

1. Timing of security issues or share repurchases is


unimportant because prices are correct on average.
2. Management should monitor the price of the firm’s
securities to see whether price changes reflect new
information or short-run momentum and/or
overreaction.
EMH vs FA vs TA
These are 3 broad theories concerning stock price
movements.
• FA :
• Key EIC variables – intrinsic value- determines under or
over priced securities. Buying under priced securities
and selling over priced securities for earning superior
returns.
• TA :
• States that FA is unnecessary. Technician believes that
history repeats itself. Tries to predict future share prices
movements by studying the historical patterns in share
price movements.
EMH vs FA vs TA
• EMH : Expressed in 3 forms – weak, semi strong and strong
forms.
• Weak form contradicts TA stating that past prices can not
be used to forecast future prices because successive
price changes are independent of each other.

• Semi strong form contradicts FA : Mkt is efficient in


dissemination and processing of information. Hence
publicly available information can not be used to earn
superior returns

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