Efficient Market Hypothesis
“I’d be bum in the street with a tin cup if the markets were efficient” (W. Buffet). In practice, all traders and external news result collectively into large fluctuations of any price of a financial product. It follows that any predictability pattern is neither detectable nor exploitable. This is basically what is called the “Efficient Market Hypothesis” (EMH) that Buffet contests: for him markets are not efficient, arbitrage opportunities exist and it’s possible to make money out of them! Of course, we have to consider any proposition by Buffet with the highest level of attention. Markets are complex systems that incorporate information about a given asset in the time series of its price. The EMH was originally formulated in 1965 by Samuelson. A market is said to be efficient if all the available information is instantly processed when it reaches the market and it is immediately reflected in a new value of prices of the assets traded. The conclusion of this ‘weak form’ of the efficient market hypothesis is then that price changes are unpredictable from the historical time series of those changes.
In 1970, E.Fama developed the first ideas on Efficient Market Hypothesis (EMH) and made a distinction between three forms of EMH: (a) the weak form (of Samuelson), (b) the semi-strong form and (c) the strong form. The strong form suggests that securities prices reflect all available information, even private information. Seyhun (1986, 1998) provides sufficient evidence that insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. The semi-strong form of EMH asserts that security prices reflect all publicly available information. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. Again, no arbitrage opportunity exists. What next? Certainly, the weak and semi-strong forms of the EMH are not fully correct and Buffet is right. Then, one can start from EMH and incorporate deviations from rational expectations in the behaviour of agents in an attempt to explain anomalies of financial markets. It raises the question of finding arbitrage opportunities! In addition, it is not so obvious that even if an arbitrage is present, we could exploit it. Since the 1960s, a great number of empirical investigations have been devoted to testing the limits of the EMH, which has been put on trial and subjected to a constant critical re-examination.