Business Finance- Efficient Market Hypothesis- Explain efficient market hypothesis (EMH) in relation to pricing of equity shares on the stock markets/UK stock exchange and discuss the significance of...

Efficient Market Hypothesis:
Solution to question 1:
Efficient Market Hypothesis:
Efficient Market Hypothesis suggests that financial markets are informationally efficient i.e. The current market price of asset/security quickly, rationally and fully reflect all the information available about the asset/security. When current price reflects all available information, the price is nothing but the fair value of securities. If a security is trading at fair value, the investor can earn only the market return from that security and no abnormal return (abnormal returns are the return higher than justified market return at the same risk level). In other words, investor cannot beat the market. He/she cannot purchase undervalued security and sell them at a higher price, and cannot short-sell the over-valued security and later on, repurchase them at a lower price. Hence, it is not possible to outperform the market by making an expert selection or by making trade at selected time.
Note: Fair value is the value of security at which willing-full, a rational and knowledgeable investor can buy or sell securities under arm-length transactions. This is also known as intrinsic value. The market price can be same as or different from Fair value of the security.
Market efficiency can be understood in also a way that above average return can be achieved by taking above-average risk. How to measure market efficiency? This can be answered by determining the time required for the market to adjust the price of a security according to the new information. If the market is taking no time or minute time to adjust the price of security, then the market is said to be fully efficient. Otherwise, the market is not considered as efficient. Empirically, the foreign currency exchange markets were found more efficient than the other financial markets.
Professor Eugene Fama is known as first introduced of efficient market hypothesis. There are three forms of market efficiency hypothesis:
1. Weak Form Market efficiency: This form of efficient market hypothesis argues that the current market price of security fully reflects the all-available current market data. The price of security at present, is independent of the price or volume in the past i.e. The historical price / volume of security does not affect the current price of the security. The implication of this hypothesis is that any investor or portfolio manager cannot make abnormal returns by doing technical analysis. All available market information is reflected in the current price of the security.
Technical analysis comprises the analysis of historical price movement, volume trend of the security trade. Based on historical trends, analyst assesses the current price / volume of security and predicts the future course of movement about the security's price. If the analysis indicates the highest value of security in the coming period, then the analyst recommends buying for that security and vice versa. According to weak form of efficient market hypothesis, the historical price/ volume bear no impact on the current or future price of security and hence the technical analysis if futile. By doing technical analysis, investor cannot achieve risk adjusted positive returns on average.
2. Semi-Strong from market efficiency: This form of efficient market hypothesis states that the current market price of a security reflects all publicly available information. In other word, the price of security is adjusted quickly and rationally for all available information in the public domain. It is to be notable that publicly available information consists both market and non-market information. Market information means past price and volume of security. The non-market information are company’s history, management, operational capabilities, competitive strength, current or past results, assets, relation with employees /regulator / creditors /debtors etc. The information is known as fundamentals of entity or company.
This form of market efficiency hypothesis implies that both technical analysis and fundamental analysis cannot make abnormal returns. As explained above, technical analysis involves analysis of historical trends in price and volume of security. So, analysis of past trend cannot help in understanding the current price and predicting the future price of security, as the price of security is independent of its past prices. Fundamental analysis or fundamental research involves research or study of fundamental information about company/security. The fundamental information about the company is mentioned above like management, earning results, competitive strength etc. Further, the information about security comprises relative valuation ratios like Price to Earning (P/E) ratio, Price to Book value (P/B) ratio, Enterprise Value to sales ratio etc., Discounted cash flow information etc. Based on the analysis of fundamental information, analyst or investor determines the intrinsic / fair value of securities. IF the current market price is lower than this derived intrinsic value, the security is regarded as undervalued and hence recommended for purchase. On the contrary, if the current market price is higher than this derived intrinsic value, the security is regarded as overvalued and hence, recommended for sale.
By going this hypothesis, the market price of security already discounted / instantly discounts all available markets & non-market information. So, there is no use of either technical or fundamental research on security and analyst/investor will not be able to make risk adjusted positive return on average.
3. Strong from market efficiency: This form of efficient market hypothesis implies that the current market price of a security reflects all information whether public or private about it. This means all past market data about security, fundamental information about security and insider information about security already factor in the current price of it. Hence, technical research, fundamental research and insider information too, are not useful in achieving abnormal returns.
The technical analysis and fundamental analysis have been explained earlier. The management and higher level officer of the company or even key employee of the company are known as an insider person of it. These insiders are assumed to possess critical information about the security or company, which may affect the price of security and which are not available in the public domain. This information is known as insider information. So, based on insider information, these insiders can trade earlier than the rest of market participants and hence can make abnormal profits. This trade mechanism is termed as insider trading. According to this form of efficient market hypothesis, the price of security already reflected / adjusted the insider information as well. Therefore, insider persons also cannot make positive risk adjusted return on average. Hence, all kinds of researches and approach / reach toward critical information are futile and should be stopped.
Efficient market hypothesis and Investment policy: If the market is informationally efficient and the price of security in the market is fair price, then there are no opportunities to earn abnormal returns. When no one can beat the market, the investment manager or even the investor should use a passive strategy of investment. Passive strategy means either purchasing or selling market index or managing portfolio in such a way that the portfolio reflects the same composition of securities as of the market. There is no use of pursuing an active strategy of portfolio management. In case of active strategy, the investor/portfolio manager does the valuation of securities, figure out undervalued/overvalued security and accordingly to the trading or manage portfolio in order to generate abnormal returns.
It would be worthless to do either fundamental analysis or technical analysis in order to search the undervalued/overvalued securities, or in order to figure out the market trend and thereby making abnormal returns. The investor or portfolio manager can increase his/her return only by Purchasing / selling riskier securities. In other words, higher return would require higher risk taking.
However, the real market doesn’t support the argument of pursuing only passive strategy. Many investors in the financial world have generated abnormal returns over the last few years or decades.
Efficient market hypothesis and corporate financial reporting:
The efficient market hypothesis implies that the investor can only market return. What they need to do is just buy and hold the security. That means reporting of individual security does not affect the investor, as the investor is concerned with the market beta (systematic risk coefficient) and not with beta of market security. Hence, corporate reporting becomes less useful for the investor. However, this argument does not hold good. Many small investors or even large investor cannot achieve proper diversification in their portfolio. They are still watching the earnings result and other events of investing company / security. Thus, the financial reporting does not become less relevant because of the existence of efficient market hypothesis.
As per efficient market hypothesis, the market price of a security is nothing but its fair value and reflects all information including the accounting information. Hence, there should be some relation between accounting data and security price behaviour, and the method of reporting should be chosen in a manner that conform to market price. However, this premise does not hold good. The recording of transaction and presentation of financial results from an entity is governed by prevailing regulations, requirements. The objective of financial reporting should be the true and fair value of financial position of the company, and not to concurrence with the current market price.
The thing to be notable here is the disclosure by firm is important. The disclosure can be made in any form / method. So, it will not impact whether the disclosures have been made in the main body of financial statements or as...