Efficient Capital Market:
An efficient capital market is one where the underlying security prices adjust quickly to the latest information available in the market and thus current prices of securities will reflect all information available for those securities. In efficient markets, investors can not earn risk weighted excess return.
Assumptions in Efficient Capital Market:
- Securities are independently valued and priced by many profit maximizing participants.
- There must be a randomness in the latest information about the security available in the market
- Securities prices must be adjusted by participants quickly to reflect the new information
Efficient Market Hypothesis (EMH):
Efficient Market Hypothesis tells that market prices fully reflects all the available information and believes that it is impossible to continuously outperform the market. This Theory was proposed by Paul A. Samuelson and Eugene F. Fama in 1960. This theory has been widely used in financial modelling of stock prices. It is also controversial in nature as it has certain assumption about human behaviour while trading in those securities.
Efficient Market Hypothesis is divided into 3 levels or forms by Fama:
- Weak Form EMH
- Semi Strong Form EMH
- Strong Form EMH
Weak Form EMH
It assumes that current stock prices fully reflect all security market information of the history of prices, rates of return, trading volume data, odd-lot transactions, block trades etc. This is called weak form as its difficult to make profits based on history of prices as the same information will be available to all the market participants.
Semi Strong Form EMH
It assumes that security prices adjust quickly to the latest publicly available information such as all non-market information like company financial statements (annual reports, income report) price-to-earnings (P/E) ratios, dividend-yield (D/Y) ratios, price- book value (P-BV) ratios, stock splits, news about economy, politics, weather forecast, war etc. It also encompasses weak form EMH.
Strong Form EMH
It assumes that stock prices fully reflect all information from public and private (insider information) resources. This means that no group of investors can continuously beat the market and outperform with their privileged access to price sensitive information. Strong from EMH encompasses both Semi strong form EMH and Weak Form EMH.