Efficient Market Hypothesis

The concept of market efficiency was first developed in the finance literature and its full form was first explained by Engene Fama.  But now-a-days this concept is being used in other areas also.  Efficient market is defined as one where prices fully reflect all the available information.  By definition then there should not exist any unexplained opportunities for profit.

It states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory.

The definition of efficient market is a little vague and its vagueness it seems, is intentional.  It can be shown that, under certain circumstances, it is not required all market operators to share exactly identical views on the future price.  Some investors may be better informed than others.

The implication of the concept of market efficiency in forex market is interesting.  Let us assume that both spot and forward markets of a currency are characterized by the following condition: (a) There are a large number of investors with ample funds available for arbitrage operations, and (b) There are not exchange controls and also no transaction costs.

In this situation suppose an American investors thinks that spot price of deutsche mark (DM) in terms of the dollar is going to be 15 per cent higher in twelve months than it is to day.  The investor may be able to profit by buying DM forward, and then selling DM spot at the end of 12 months.  If his judgment proves right, his profit will be 15 per cent less the premium paid for forward DM (transaction cost is nil as assumed).  As the market information is perfect, other investors will follow suit, and the forward DM will be bid up until the premium is high enough to prevent any further speculation.

One interesting question is: how long will the speculation continue in the market to have a share of the profit. This is not indefinite, as at some point investors will realize that, although the potential of profit from speculation is not zero, the probable reward is not great enough to compensate for the risk of being wrong.  Thus equilibrium will be reached and speculation will spot at the point where the gap between the forward rate and the expectation of the market of the future spot rate is just equal to the required risk premium charged, or in equation it becomes

Ft (t+1) = Et(St+1) + rt

Where LHS is the logarithm of forward price of DM at time t for delivery at period (t+1) and rt is the risk premium.  In the above equation the forward rate reflects both the publicly available information congealed in the rational expectation Et(St+1) and the attitude of the market towards risk revealed in the risk premium.  Thus the equation shows the equilibrium in the efficient market.  The interpretation of efficiency explained here corresponds to what E.  Fama called semi-strong form of efficiency (FAMA, 1970).  Strong form of efficiency applies when the market price reflects all information, whether publicly available or not.

It is quite possible to imagine a situation where the market price reflects only the restricted information set which can be used in the formation of weakly rational expectations.  Here the expected value in the equation would be conditioned on the past value of the time series, and not on the universe of publicly available information.  This helps in defining a weakly efficient market.

 

A weakly efficient market is one where the market price reflects the market information in its own past history.  It implies that there no longer exists any opportunity to profit by making use of past time series of prices alone.

One interesting aspect of weakly efficient market is that there will normally remain opportunities to make a profit by the exploitation of information additional to the past time series of prices.  Another implication of market efficiency is the unbiasedness of the market.

A forex market is said to be unbiased when the forward market is efficient and investors are risk neutral, so that the forward rate is equal to the mathematical expectation of the spot rate at the time of the maturation of the contract.

Efficient of inefficient players in the forex market are big and they are equipped with very powerful computers with dedicated software.  In spite of the fact that they have access to massive data set and powerful software, calculations go wrong and survey data repeatedly point out irrational movement of expectations.  May be this is another mystery of the market forces.

 

 

Reference: Fama E F, Efficient Capital Markets: A Review of Theory and Empirical Evidence, Journal of Finance, 25, 1970, 383-417

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