Efficient Market Hypothesis Essay

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Objectives Capital market, being an essential element of today’s economy, demands an intensive and special attention. The objective of this study is to look into every aspect of Bangla-desh capital market and identify its various pros and cons along with efficient market hypothesis. The specific objectives of this study are: To give an overall idea about the capital market-its structures, functions, importance, etc.

To compare the relative conditions of Bangladesh capital market effeciency. MethodologySecondary data and information were used in preparing this seminar paper, and these were collected through teamwork by adopting the following processes: * Visiting the website of followings: Dhaka Stock Exchange (DSE) Dhaka Chamber of Commerce (DCC) Bangladesh Bank (BB) Monetary Policy Department (MPD), BB * Consulting books from different libraries of: Bangladesh Institute of Development Studies (BIDS) Dhaka Chamber of Commerce (DCC) Bangladesh Bank (BB) Other Books Limitations of the study The vast majority of efficient market research to date has focused on the major United States and European securities market.Far fewer have investigated the developing and less developed countries markets; and no study on this area has been performed on the Dhaka Stock Exchange (DSE). The study seeks evidence supporting the existence of at least weak-form efficiency of the market. : There was a little scope for research on this crucial subject as all the data was secondary and no way to collect primary data was available. Lack of a wide coverage due to time constraint.

We did not have much time to visit all the relevant places and meet respective personnel.Only secondary data was used, but there is no alternative of primary data to en-sure the accuracy and effectiveness of the study. CAPITAL MARKET IN BANGLADESH Definition Capital market can be termed as the engine of raising capital, which accelerates industrialization and the process of privatization. In other words, capital market means the share and stock markets of the country.

It is a market for long term fund. With the emergence of the need for infrastructural development projects, for setting up of new industries for entrepreneurial attempts-now there are more frequent needs of funds. Participants in the capital markets are many.They include the commercial banks, sav-ing and loan associations, credit unions, mutual saving banks, finance houses, finance companies, merchant bankers, discount houses, venture capital companies, leasing companies, investment banks & companies, investment clubs, pension funds, stock ex-changes, security companies, underwriters, portfolio-managers, and insurance compa-nies. Functions The functioning of an efficient capital market may ensure smooth floatation of funds from the savers to the investors.

When banking system cannot meet up the total need for funds to the market economy, capital market stands up to supplement.To put it in a single sentence, we can therefore say that the increased need for funds in the business sector has created an immense need for an effective and efficient capital market. It faci-litates an efficient transfer of resources from savers to investors and becomes conduits for channeling investment funds from investors to borrowers. The capital market is required to meet at least two basic requirements: (a) it should support industrialization through savings mobilization, investment fund allocation and maturity transformation and (b) it must be safe and efficient in discharging the aforesaid function.It has two segments, namely, securities segments and non-securities segments.

Importance of Capital Market in the economy The capital market is the market for long-term loans and equity capital. Developing countries in fact, view capital market as the engine for future growth through mobiliz-ing of surplus fund to the deficit group. An efficient capital market may perform as an alternative to many other financing sources as being the least cost capital source. Espe-cially in a country like ours, where savings is minimal, and capital market can no won-der be a lucrative source of finance.

The securities market provides a linkage between the savings and the preferred in-vestment across the business entities and other economic units, specially the general households that in aggregate form the surplus savings units. It offers alternative in-vestment windows to the surplus savings units by mobilizing their savings and channe-lizes them through securities into optimal destinations. The stock market enables all individuals, irrespective of their means, to share the increased wealth provided by competitive enterprises.Moreover, the stock market also provides a market system for purchase and sale of listed securities and thereby ensures liquidity (transferability of securities), which is the basis for the joint stock enterprise system. (The existence of the stock market makes it possible to satisfy simultaneously the needs of the firms for cap-ital and of investors for liquidity. ) Especially at times when the banking sector of the country is facing the challenge of bringing down the advance-deposit ratio to sustaina-ble level, the economy of the country is unfolding newer horizon of opportunities.

Due to over-exposure level of the financial system the securities market could play a very positive role, had there been no market debacle. Due to the last market crash and follow through events, it will be difficult to utilize the primary market to raise significant vo-lume of funds. Thus the greatest economic importance of securities market at this point can be understood from the opportunities being lost. Bangladesh having its target to become a middle income country must have significant level of rise in investment, which at the present state of banking system cannot be met.

The securities market could play the key role in meeting these huge investment demands if the secondary market would remain stable. The capital market also helps increase savings and investment, which are essential for economic development. An equity market, by allowing diversification across a variety of assets, helps reduce the risk the investors must bear, thus reducing the cost of capi-tal, which in turn spurs investment and economic growth. However, volatility and mar-ket efficiency are two important features which will ultimately determine the effec-tiveness of the stock market in economic development.

If a stock market is inefficient due to insufficient informational supply, investors face difficulty in choosing the optim-al investment as information on corporate performance is slow or less available. The resulting uncertainty may induce investors either to withdraw from the market until this uncertainty is resolved or discourage them to invest funds for long term. Moreover, if investors are not rewarded for taking on higher risk by investing in the stock market, or if excess volatility weakens investor’s confidence, they will not invest their savings in the stock market, and hence deter economic growth.The emerging stock markets offer an opportunity to examine the evolution of stock return distributions and stochastic processes in response to economic and political changes in these emerging economies. What is the Efficient Market Hypothesis? In 1953 Maurice Kendall published a study in which he found that stock price movements followed no discernible pattern, that is, they exhibited no serial correlation.

Prices were as likely to go up as they were to go down on any given day, irrespective of their movements in the past. These results lead to the question of what, exactly, influenced stock prices.Past performance obviously did not. In fact, had this been the case, investors could have made money easily. Simply building a model to calculate the probable next price movement would have enabled market participants to gain large profits without (or with reduced) risk.

On the other hand, if everybody could have done so, stocks that were about to rise would have risen instantly, because large numbers of investors would have wanted to buy them, while those holding the stock would not have wanted to sell. This mechanism suggests that the market “prices in” the performance data that is already available about a stock.Definition of Market Efficiency The concept of efficiency adopted for this thesis is one regarding the incorporation of information into security prices. Generalizing from the results of the above paragraph leads to the proposition that any available information which could influence a company’s stock performance should already be reflected in said company’s stock price. In an efficient market, therefore, security prices should equal the security’s investment value, where investment value is the discounted value of the security’s future cash flows as estimated by knowledgeable and capable analysts.Under this definition, the one thing that can still influence stock prices is new information.

When new information about a company becomes available, the above process makes stock prices move immediately to reflect the new situation. Naturally, this new information needs to be unpredictable; otherwise the prediction about the new information (which is itself a piece of information) would already have caused share prices to change. These considerations suffice to formulate the efficient market hypothesis. In its original postulation, it stated that “an efficient market is one in which stock prices fully reflect available information.

Later texts have weakened this definition to allow for prices to be sufficiently different from full-information prices for investors to become informed. A good description of market efficiency and the underlying mechanics is the one by Cootner (1964): “If any substantial group of buyers thought prices were too low, their buying would force up the prices. The reverse would be true for sellers. Except for appreciation due to earnings retention, the conditional expectation of tomorrow’s price, given today’s price, is today’s price.

In such a world, the only price changes that would occur are those that result from new information. Since there is no reason to expect that information to be non-random in appearance, the period-to-period price changes of a stock should be random movements, statistically independent of one another. ” In a perfect market, these criteria are obviously fulfilled. In such a market transactions and information are costless, implying that market participants have full information and can react to news without incurring costs.Nevertheless, while perfect markets are a sufficient assumption for market efficiency, they are not a necessary condition. The Three Forms of Market Efficiency In economic and financial theory a distinction is made between three forms of market efficiency.

The basis of this separation is what is meant by the term “all available information”. Each stronger form of efficiency incorporates all weaker forms of efficiency. In weak-form efficient markets stock prices reflect market trading data and information derived from it. Examples of market trading data are past prices, volume or short interest.This data is generally easily available and, according to this theory, should therefore be reflected in current prices. If weak-form efficiency holds, stock prices should be composed only of three components – the last period’s price, the expected return on the stock and a random error term which has an expected value of zero.

This random error is due to new, unexpected information released in the period observed. Their relationship can be expressed as follows: Pt = Pt? 1 + E[r ]+? t? 1| | where Pt is the stock price in period i , E[r] is the expected return on the| | tock and ? t ? 1 is the random error term for period t ? 1 , with E[? t ]= 0 ? t and corr(? t? 1 ,r)= 0 ? t . Weak-form efficiency is a prerequisite for many asset pricing models (CAPM, APT) and for option valuation models following the Black/Scholes and Cox/Ross/Rubinstein methods. Semi strong-form efficient markets reflect all publicly available information influencing the company’s value in stock prices immediately. Above and beyond the requirements of weak-form efficiency, in this model data about the firm’s products, operations, balance sheet, patents, etc.

is priced in.Strong-form efficiency postulates that stock prices reflect all relevant information, including information which is only known to company insiders. This definition implies that these insiders, who are privy to information before it becomes known to the rest of the market, also cannot earn any excess profits. In theory, if these individuals tried to trade on their information, the market would recognize the attempt and prices would adjust before the trade could go through. In practice, the insider trading rules of the SEC and similar regulatory bodies aim at preventing insiders from rofiting from their superior knowledge by prohibiting insider trading for said individuals, their relatives and anybody who is supplied with their information. In the academic community there are also proponents of the view that, if insider information is not available to investors, strong-form efficiency can be considered to hold regardless of whether the availability of insider information would lead to excess returns.

14 Strong-form efficiency, naturally, is the most contested of the three models. For it to hold, weak and semi strong-form efficiency have to hold first.

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