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EMH and the Theory of Efficiency Markets

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Published: 6th Dec 2019

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Tagged: Economics

Efficient Market Hypothesis and the Theory of Efficiency Markets

Over the two last decades, extensive studies and research has documented the existence of weak form efficiency market and their possible explanations (Brooks 2007). Many researchers have carried out research on stock markets using different data and time scales to prove the international evidence of this efficiency (Brooks and Kim 2008). Therefore, this essay will cover a wide range of literature, models and theories related to this subject area with the aim of evaluating previous work and forming the theoretical framework on which this essay is based.


Efficient Market Hypothesis

The concept of “efficient market hypothesis” is one of the well studied areas in finance. It shed a long shadow of uncertainty on every step to forecast financial assets prices (Fama 1970). It state that prices of financial assets, at all important times and fully identify all existing information used in forming the market prices. EMH assumes that share prices incorporate all information in such that changes in prices are only due to new or unanticipated events (Fama 1970).

Fama (1970) an “efficient market” is defined as a market where share prices always fully reflect all available information about the company or firm. This implies that investors respond quickly to latest information regarding securities which is reflecting in the price changes. That is, if a market is efficient, the new information about the security is already incorporated in the price making it impossible for investors to make an abnormal profit. However Leory (1989) criticized fama’s definition of “efficient market” as being empty and tautological. He argued that the definition is unclear about how the market can efficiently use all available information to determine stock prices, if investors have diverse information and Grossman (1976) also highlighted disagreement in fama’s definition of “fully reflect”. He pointed out that if prices fully reflect all available information, then investors do not need to search for information in making decisions on shares to buy (Grossman and Stiglitz 1980). Malkiel (2003) argued that markets can be efficient even if investors are irrational and stock price are more volatile than can be explained by fundamentals such as earnings and dividend. Thus, in any information concerning efficient market either past or currents level cannot be use to predict the future price of stock.

Based on the above argument of an efficient market, it shows that there are different ways to test weak form efficiency market. Fama (1970) recommended four models for testing efficiency market which is display in the diagram below.

The Sub martingale model

The Expected Return or Fair Game model

Recommended model by Fama (1970)

Market conditions consistent with efficient market

The Random Walk Model.

Theory of Efficient Market



The fair Game model.

Generally, model states that a stochastic process Xt with thecsituation on information set It, is a fair game if it has the following property:

E (Xt+1| It) = 0 (8.1)

However in terms of stock market, Fama (1970) bring in a model of the EMH that result from the Fair Game theory and expressed. This theory means that the excess market value of security j at period t+1 (xj,t+1).

Is the difference between real price and estimated price on the basis of the new information set. Based on the fair game theory, the excess market value and excess return are equals to zero

The Submartingale theory

The model identified that, In prices has one significant empirical implication. Reflect on the set of one security and cash mechanical trading rules by which we identified systems that concentrate on person securities and that define the conditions under which the investor would be in a possession of a given security or to hold cash at a particular period.

Market conditions consistent with efficient markets

Market conditions are based on different assumption which includes, presence of perfect competitions which implies that all participants are price takers, the absence of transactional cost in security trading (Condoyanni 1989) existence a general agreement between, availability of cost-free information to all market participants and, the participants on the implication of current information on current prices.

The Random Walk model

The Efficient Market Hypothesis is based on the assumption that stock prices and returns follow a random process. (Fama, 1970) defines “random walk” by the fact that price changes are independent on each other, the theory of random walk in stock prices hinges on two hypothesis; Firstly, that successive price changes are independent and these changes conform to some probability distribution (Fama,1965). This implies that investors react instantaneously to information causing the prices to fluctuate thereby eliminating any profit opportunities. From the study of Keane (1983) the “Random Walk theory” defines market efficiency in terms of lack of dependence between successive price movements. This implies that short-run changes in stock prices cannot be predicted (Malkiel 1990) thus investment advisers, earning predictions and complicated chart patterns are not important.

Based on the above discussion of different types of model, the most appropriate one to measure the weak form efficiency is the Random Work model as state by (Fama 1993). Hence Random work model will be use to test weak form efficiency in the Nigerian market.

Market conditions consistent with efficient markets

Market conditions are based on different assumption which includes, presence of perfect competitions which implies that all participants are price takers, the absence of transactional cost in security trading (Condoyanni 1989) existence a general agreement between, availability of cost-free information to all market participants and, the participants on the implication of current information on current prices.

The above conditions are unrealistic and therefore the presence of imperfections in the real world, like availability of high transactional cost, raises concerns on how sufficient these imperfections are in affecting the pricing mechanisms of the market and forms the basis on which, this theory is criticized. On the basis of unrealistic assumptions the concept of the efficient market is considered as a hypothesis.

Forms of market efficiency

Roberts (1959), differentiate three levels of ME based on information set reflected in stock prices. However, Fama (1970) used its theoretical framework to identify the EMH and categorized it in three forms.

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Forms of Market Efficiency (Discussion)

Weak form efficiency

Fama (1970), posits that a market is said to be weak form efficient if all information about past prices are reflected in current stock price. This means that investors cannot use past prices to make their present decisions as all information is already incorporated in the present or current market. However stock prices move independently of any past movements making it difficult to earn excess returns by using previous prices. Thus, the use of chat and other technical analysis based on historical prices in a bid to predict future prices cannot improve investor’s ability to earn abnormal profits (Lo 2007).

Semi-Strong form efficiency

The market is efficient in the semi-strong sense if share prices respond instantaneously and in an unbiased manner to new information. The semi-strong form asserts that current prices fully reflect public knowledge about the underlying companies, and that efforts to acquire and analyze this knowledge cannot be expected to produce superior investment results (Lorie & Hamilton 1973). Therefore the possibility of earning superior rates of return by reacting to annual reports, announcements of changes in dividends and stock splits does not exist. Thus, although the users of this information might differ among themselves about the significance of the new data, the implication is that the prices that are actually arrived at in such a market would invariably represent the best interpretation of the information. This makes it futile for investors to search for bargain opportunities from an analysis of published data (Keane 1980).

Strong form efficiency

This stipulates that private information or insider information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security’s current market price. That’s mean, even the company’s management (insider) are not able to make gains from inside information they hold. They are not able to take the advantages to profit from information such as take over decision which has been made ten minutes ago. The rationale behind to support is that the market anticipates in an unbiased manner, future development and therefore information has been incorporated and evaluated into market price in much more objective and informative way than insiders.

Review of weak form efficiency markets

Research shows that many researchers have been devoted to testing the weak-form efficiency market. Early studies by (Fama 1965; Samuelson 1960 and Working 1930) studied it and could not disprove a random walk. However random work was tested in both developed and developing markets and it is found to be weak-form efficient in both markets (Fama 1991).

Review of weak form efficiency in the Developing market

However, Antoniou et al (1997) Posits that African market may be weak form efficient because they have weak institutional infrastructure facilities view Appiah-Kusi and Menyah (2003) suggest that institutional infrastructure efficiencies are desirable in their own right and ought to be stressed by both regulators and market participants. However, they are not sufficient conditions for weak form efficiency in African market. In their view rational investors are not likely to allow profitable opportunities to remain unexploited because they are not inclined to benefit from weak institutional infrastructure.

Prior studies of weak form efficiency in African stock market.

Compared to the volume of studies conducted in developed market only a few studies have been published on the efficiency market hypothesis in Africa. The general assumption is that emerging markets are less efficient than developed market. However, the few studies on African stock markets includes those that have examined single markets (e.g Samuels and Yacout 1981, Parkinson 1984, Ayad. 1984, Dickinson and Muragu, 1994, Osei 1998, Olowe 1999 Mecagni and Sourial 1999, Asal 2000, Adelegan 2004, Dewotor and Gborglah 2004, Ntim, Opong and Jo Danbolt 2007) others that focuses on group countries include Claessens et al (1995), Magnusson and Wydick (2002), Smith et al (2002), Appiah-Kusi and Menyah (2003), Simons and Laryea (2004), Jefferis and Smith (2005). Given the regulatory , infrastructural and institutional challenges pointed out in these markets by (Antoniou et al 1997) and Appiah-kusi and Menyah (2003) it is worth noting based on the foundational frame work of the efficiency market Hypothesis by Fama (1965, 1970) that the proof of random work is found in some of these African markets.

Samuel and Yacout (1981) and Parkinson (1984) were among the first to examine the evidence of the weak form efficient market Hypothesis in Africa using serial correlation test. However, their results were not consistent. While the weak form market efficiency in weekly price series of 21 listed stocks in Nigeria from 1977 to 1979 was accepted in the result of Samuel and Yacout that of Parkinson (1984) reject the Null hypothesis that monthly price series of 30 listed stocks in the Kenyan Stock Exchange from 1974 to 1978 is weak form efficient. Using a combination of runs and serial correlation test Dickson and Muragu (1994) examined the weak form efficiency of weekly stock series of 30 listed firms in the Nairobi Stock exchange from 1979 to 1988. Contrary to the findings of Parkinson (1984) their result shows that successive price changes are independent of each other for most of the stocks examined

Jefferis and Smith (2004) classified African stock market into four categories, such as South African market(e.g South Africa), Medium sized markets(e.g Egypt, Morocco, Nigeria, Zimbabwe), small new markets which have experienced rapid growth(e.g Botswana, Ghana, Mauritius) and small new markets(e.g Swaziland, Zambia) which are yet to take off. Appling a GARCH model with time varying parameters, they test the changing of efficiency for seven African stock markets(South Africa, Egypt, Morocco, Nigeria, Zimbabwe, Mauritius and Kenya) from early 1990 to 2001. This test, which can identify changes in weak form efficiency through time, find evidence that the Johannesburg stock market is weak form efficient throughout the period, while Egypt and Morocco are weak form efficient from 1999 and Nigeria from early 2001

Other robust test of weak form efficiency in Africa that control for thin trading and nonlinearity of return consistent with the findings of Appiah-Kusi and Menya is Ntim, Opong and Jo Danbolt (2007) who use a well specified Lo and Mackinlay (1988, 1989) variance ratio test and Wright’s (2000) non parametric test to examine the weak form efficiency of the daily all share index price series of Ghana Stock Exchange and 20 listed firms from 1990 to 2005.

Overview of Nigerian stock exchange

The Nigerian stock Exchange was incorporated on September 15, 1960 and it commenced operation on June 5, 1961 as the Lagos stock exchange with 19 securities listed for trading. (www.nigeriastockexchange.com). Sixteen years after the Lagos Stock Exchange commenced operation, it was renamed the Nigerian stock Exchange in 1977 following recommendation of the government Financial System Review Committee of 1976 with branches established in different major commercial cities in Nigeria. At present there are thirteen branches of Nigerian stock Exchange including one at the capital city Abuja. Each of these branches operates an electronic trading system. The exchange provides the platform for trading existing securities and also encourages enterprises to gain access to public listing. The Nigerian Stock Exchange operates two main Exchange. These includes the first tier market where relatively large enterprises existing securities can be traded with more stringent rules, and the second tier securities market where listing requirements are less stringent to encourage the listing of small and medium scale enterprises.

The apex regulatory body of the Nigerian Stock Exchange is the Security and Exchange Commission, which was established to protect investors and promote capital market growth and development in Nigeria. In the past, it was called the capital issue committee in 1961 and later Capital Issues Commission in 1973 before it was formerly named the Security and Exchange Commission under the SEC Decree No 71 of 1979 amended in 1988 and 1999.

According to Ndi Okereke (2010) review of NSE Market performance, total value of 266 listed securities on the Nigerian Stock Exchange dropped by 26.5%, from N9.56 trillion($80.6b) in 2008 to stand at N7.03 trillion(47.75b) at the end of 2009. The decline in market capitalization resulted mainly from equity price losses and the delisting of 64 securities which include 11 equities and 53 fixed income securities. Compared with the Preceding five years, the primary market activities (e.g IPOS, Private placement etc) was less active during 2009, in terms of the number of application received and issues offered for public subscription. Ndi Okereke (2010) the Director General of the Nigerian Stock Exchange attributed this to the liquidity crisis and the Overriding pessimism of investors.


This essay introduced the concept of market efficiency distinguishing between a locative, operational and informational efficiency. Various definitions and the development of efficient market were discussed .The theoretical framework of the efficient market was introduced highlighting the rational expectation of investors, fair game, submartingale and random walk models. The different forms of efficiency based on the information available to investors were discussed. Various studies on the empirical evidence of market efficiency were reviewed, particularly the evidence of weak form efficiency in developed, emerging and African Markets.

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