November 24, 2011

Stock Market Efficiency Theory and Implications for Financing Decisions

Stock Market Efficiency Theory and Implications for Financing Decisions

Stock Market Efficiency Theory and Implications for Financing Decisions

Financial Management Revision Article

Stock prices follow a distribution called random walk distribution.

Authors

Random walk hypothesis of stock prices


Stock prices follow a distribution called random walk distribution. The simple explanation of this distribution is that the best estimate for the future state of the system is the present state itself. Random walk is explained as the walk of a drunkard. You don't know when he will turn and the best estimate for his future position is present position only.

A Poem written by me on random walk. The poem is from the knol Stock Market Poems - Collection 2 (all rights reserved).

Trend Talk and Random Walk
 
You can make money in quick time, said Dow
Speculate and make money now
I shall tell you how
through a theory named Dow.
 
Dow was the editor
of a stock market mirror
Wall Street Journal
for stock market personnel.
 
Trends, trends, trends
First one is for long term
Second one is for medium term
Third may be random
whose meaning you cannot fathom.
 
Follow the trend
which is your friend
You can make money in quick time
even with a dime
from anywhere
a telegraph office is there
 
 
There is no trend
to follow and send
stocks to further high end
Said a statistician
trying to become a physician.
 
Stock prices follow random walk
Similar to that of a drunkard
who may be blinkered
You don't know when he will turn
Each and every step is uncertain.
 
Each move is independent
irrespective of the time spent
Charts are valueless
You are clueless
 
Random walk, random walk
Ignore Wall Street talk
Save your time and dime
Invest for long time
Avoid the short time
 
Trend talk and
random walk
clash every day
Some one will pay
the other every day
 ----------------------




Efficient market hypothesis/theory (EMH)


The random walk hypothesis was extended to efficient markets hypothesis. According to this theoretical conjecture,stock markets are efficient with respect to processing the information.


Weak form, Semi-strong, and Strong forms
As the theoretical conjecture talks of efficient information processing, levels of information were brought into the refined forms of EMH.

Historical information released by the stock markets
Information released by the company regarding future activities
All information including information not released by the company.

Weak form EMH says stock market is efficient in processing historical information released by the stock markets.

Semi strong form EMH says stock market is efficient in processing information released by the company regarding future activities.

Strong form EMH says stock market is efficient in processing all information including information not released by the company.



Empirical evidence


Serial correlation tests
Runs tests
Filter tests

Event studies

Studies of performance of mutual fund managers or schemes


Market efficiency  - Implications for corporate finance


If the market is efficient, companies need not time their public issues.
 

References

 

Prasanna Chandra, Financial Management, 5th Ed.,  Tata McGraw Hill, 2001

Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001

 

Copy posted to http://nraomtr.blogspot.com/2011/11/stock-market-efficiency-theory-and.html

 
 

Comments

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Nifty Tips - 30 Sep 2011

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