‘The Efficient Market Hypothesis (EMH) continues to provide a convincing explanation of how asset prices should respond to different types of information, but it does not provide a very a  good account of the pricing of a firm’s debt and equity. Hence, the EMH is of little relevance to corporate managers.’ Explain and discuss this contention.

The efficient market hypothesis is a proposition which articulates that the market prices of security are a reflection of available information to the members of public. This proposition states that the markets price of securities such as shares traded in any stock exchange will vary or fluctuate according to the nature of information available to the members of the public. For instance information on company profitability, mergers, acquisition and business combination, dividend declaration and investment project that a firm intends to undertake are some of the information that influence the market price of securities.

In addition to definition delineated above, efficient market hypothesis can also be delineated into three different ways, that is, allocative efficiency, operational and information efficiency.

            Allocative efficiency

A market is considered to allocative efficient if it channels its direct savings towards the most efficient prolific project. In this case, if an enterprise is efficient it will find it easier to raise funds and this results to foster of the economy arising from the efficiency (Ogilvie, 2006).

Allocative efficiency is perceived to be at its optimal if savings cannot be a channelled to an enterprise or project that would result to higher economic prosperity. .  In order, to achieve allocative efficiency in the financial market , the market should contain a  fewer  number of financial intermediaries such that funds are allocated directly from savers to users.

            Operational Efficiency

Operational efficiency can be simply delineated in general as the minimization of transaction cost. This efficiency concept relates to the cost of conducting business, or the cost of capital that is the interest cost charged by the lender on money borrowed to the borrower. If the transaction cost is high this usually translates to high cost of using the financial markets. (Elton 2010). Therefore, transaction should always be at its minimum in order to increase operational efficiency especially where there is fair completion between the various market players. In order to increase operational efficiency then there is need to increase the number of market players who can be able to participate in the market continuously (Elton 2010).

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            Information Efficiency

Information efficiency relates to extent that the information available to the members of public regarding the future panorama of a security is reflected in the present price of the said security. If all parties have the same information which is reflected in the present price of the security at their disposal then conducting investigation on securities becomes fair to all parties. This levels the playing ground for all market participants, because all the parties have access to same information which also reflected by the security price. Information efficiency is of great significant to financial managers since it indicates the effect of management decision will quickly and accurately be reflected in security prices (Elton 2010). The concept of Efficient market hypothesis is main based on information processing efficiency.  It articulates that stock markets are proficient if and only if is reflected in security prices accurately and rapidly(Elton 2010).

Efficient Market Hypothesis Levels Efficiency

Efficient Market Hypothesis efficiency can be divided into 3 different levels:

 Weak form level of efficiency

Weak for level of efficiency indicate that the historical price of securities can be used to articulate the changes in the security prices. According to this level of efficiency security price changes are pegged to information changes in historical security changes. If this proposition is true, then would easily be able to forecast the future security prices by studying the historical movements and patterns of security prices. The assertion of this level of efficiency then investors who rely on technical analysis would never make arbitrage profit since all parties holding  such security are can be easily able to articulate the future prices of security from historical patterns and movements of security prices. However, scholars have conducted studies to test practicality of this level and asserted that changes in price of securities are random and not trend wise, there is no correlation between historical price movement or trend and changes in security prices.

Semi-Strong form level of Efficiency

This level of efficiency articulates that security prices are a reflection of information available to the members of the public about the corporation attached to such security .Information referred in this case includes both past and present information. Under this level those investor who relies on fundamental analysis will not be able to take home higher returns consistently (Scholes, 1972). Fundamental analysis involves critical reviewing the company financial statement in order to determine the theoretical prices of the securities and also ascertain securities are either overvalued or undervalued. According to fundamental analysis theory, every security has an intrinsic value which is asserted to be equivalent to the summation of the present value of all future cash flows (Scholes, 1972). In order to prove the semi-strong efficiency level events studies are usually conducted. Event studies is an analysis on the market to able to accurately predict the effect of information even before their release, such events may include mergers and acquisition, Death of CEO of company, Changes in dividend policy Stock splits, and investment in ventures that are profitable (Scholes, 1972).

            Strong form level of Efficiency

Under this level, the price o securities are said to reflect all information available both private and public information. Under this proposition publication of information that was previously private do not have any influence on share prices (Malkiel, 2003). Under this proposition the financial managers aim at maximizing the shareholders wealth through maximizing the Net present value of every investment project. The tests carried at this level mainly concentrate on individual investors and fund managers (Malkiel, 2003).

Relevancy of Efficient market Hypothesis

The Timing of Financial Policy

It has been argued that, there are a correct or wrong periods to issue securities. For example, a company should always issue new securities when the market is experiencing fostered trading rather than when the activities in the exchange market are low.  If the marketer were considered to be efficient, however, price of securities have been found to be difficult to ascertain, thus it is difficult for the mangers to conclude that, on a certain day the prices of security being issued will be high or low. Timing other policies for example when to release of financial statements, or when to make announcement of stock splits, have no effect on share prices.

Project Evaluation Based Upon NPV

In evaluation of new investments, financial managers usually use the required rate return which careworn the securities which are traded in capital markets. For instance a required rate of return may be ascertained from the rate of returns that is expected by the company shareholder of companies which have invested in projects with similar risk. This is based on the assumption that the market is efficient, that is the securities are priced according to the risk that they bear (Jensen, 1969). However, if the market is inefficient then the financial managers may be wrong in appraising the project since their NPV estimate would be unreliable (Jensen, 1969).

Creative Accounting

In an efficient market, prices of securities are based upon present value expected future cash flow. Therefore, the security prices reflect all current information available to the members of the public.  This implies that companies which are list in an stock exchange are not attempt to distort information as this will be reflect in the stock of such a company.(Lee, et al 2009). As discussed earlier security prices are pegged on the cash flow of the firm and not the accounting profit therefore, it will be hard to manipulate the cash flow of the firm as compared to accounting profit which is vulnerable to changes , for example  in  depreciation method either to increase or decrease accounting profit (Lee, et al 2009).

Mergers and Takeovers

If the price of securities were correct, then the purchase of a security would be a zero NPV transaction.  If this is correct then, the underlying principle following mergers and takeovers may be questioned.  If firms are acquired at their exact equity value then acquirers are breaking even.  If they want to make considerable gains from the acquisition, then they would have to rely on synergy in economies of scale to provide the saving.  Usually the predator pay the current value equity and a premium implying that the securities are not correct valued. Therefore, the markets are not fully efficient (Ogilvie, 2006).

References

Fama, E. (1965) The behaviour of stock market prices. Journal of Business, 2, pp.34-105.
Fama, E. Fisher, L, Jensen, M., and Roll, R. (1969) The adjustment of stock prices to new
information, International Economic Review, 10. 1. pp.1-21.
Fama, E. (1970) Efficient capital markets: a review of theory and empirical work. Journal of
Finance, 25, 3, pp.383-417
Fama, E. (1991) Efficient Markets II. Journal of Finance, 49, 3, pp.1575-1617.
Jensen, M. (1969) Risk, the pricing of capital assets, and the evaluation of investment portfolios,
Journal of Business, 42, pp.167-247.
Malkiel, B. (2003) The efficient market hypothesis and its critics, Journal of Economic
Perspectives, 17, 1, pp.59-82.
Malkiel, B. (2004) A Random Walk Down Wall Street. Norton
Scholes, M. (1972) The market for securities substitution vs price pressure and the effect of
information on share price, Journal of business, 45, pp.195-212.

Elton, E. J. (2010). Modern portfolio theory and investment analysis (8th ed.). Hoboken, NJ: J. Wiley & Sons, pp.398-417

Lee, A. C., Lee, J. C., & Lee, C. F. (2009). Financial analysis, planning & forecasting: theory and application (2nd ed.). Singapore: World Scientific, pp.287-315.

Ogilvie, J. (2006). Management accounting financial strategy. Oxford: CIMA Pub. , pp.69- 75.

(Elton 2010)

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