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Capital Market Analysis: A Dicussion On Efficient Market Hypothesis

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Answer to Question 1:

Efficient Market Hypothesis was firstly brought forward by E. Fama in 1960s. Its main believing is in that security prices fully reflect all available information in an efficient market, which allows investors to earn no above average risk-adjusted return (Fama, 1965). Although some technical studies and opportunistic investors have stretched hard in searching for proofs to challenge the efficient market hypothesis, and to prove above average returns could be gained by predicting the future price using the existing information, their efforts result only in finding of the ÐŽ®anomaliesЎЇ in the market which are destined to self-destructing in the long run or being proved worthless taken the transaction cost.

Accepting the ideas of efficient market hypothesis and based on the collective effort of Sharpe, Treynor, Lintner, and Mossin (see Perold, 2004), Capital Asset Pricing Model (CAPM) was developed in 1960s as a modified form of Sharpe Ratio in evaluating financial assets returns and prices versus risks in the form of:

E (ri) = rf + ¦Ð'i [ E(rm) ЁCrf ] .

From the CAPM model, Jensen (1968) derive his risk-adjusted measure of portfolio performance (now known as "Jensen's Alpha").The formula given below demonstrates the function of ¦Ð', and is used to determine the excess return (the amount by which the portfolio's actual return deviates from its expected return). Like Treynor, Jenson also considered only the un-diversifiable risk, assuming that the portfolio eliminates the diversifiable risk.

ri = ¦Ð' + rf + ¦Ð'i [ E(rm) ЁCrf ] = ¦Ð' + E (ri)

¦Ð' = ri ЁC rf ЁC ¦Ð'i [ E(rm) ЁCrf ]

¦Ð' here is named as JensenЎЇs Alpha, as illustrated in diagram:

This measure indicates the difference between the portfolio's actual return and its expected return. According to efficient market hypothesis, the portfolio return should be on the SML, which means JensenЎЇs alpha is supposed to be zero and that indicates the portfolio was able to earn just its expected return.

According to the empirical research The Performance of Mutual Funds in the Period 1945-1964(1968), Jensen found that the average ¦Ð' of the 115 mutual fundsЎЇ performance over the period is negative, which means that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance (while random chosen portfolios may have ¦Ð' at least equal to zero) (Jensen, 1968). By this means, it could echo the CAPM model and perform as strong evidence of the efficient market hypothesis, by which no above average profit could be earned given risk level.

Answer to Question 2:

Malkiel believes that financial markets can reflect new information rapidly, for the most part, accurately. And he believes that such markets do not allow investors to earn above-average returns without accepting above-average risks. Although he do not deny that the market pricing is not always perfect, nor does he disagree that some psychological factors influence securities prices. He still believes that in and overall and long-term view, financial market is efficient for the following reasons:

First, Malkiel distinguished statistical significance from economic significance, arguing that the statistical significance giving rise to momentum are extremely small and cannot last long. Also the large amount of transaction cost of exploring the momentum will offset the benefit gained, therefore inferior to EMH based strategy like buy-and-hold.

Second, the market is becoming more and more efficient. ÐŽ®In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.ЎЇ (Investor Home n.d.) There are some predict patterns appear to help investors to beat the market. The biggest limitation of these patterns is that ÐŽothey will never be useful for investors after they received considerable publicity.ÐŽ± Using ÐŽ®January EffectЎЇ as an example, when every investor is aware of this non-random effect, everyone would like to buy stocks in December and sell them in January. While if everyone wants to do this, in order to buy in December and sell stock in January successfully, people may probably buy stocks successfully in late December and sell stocks in early January. Considering the big transaction fee, it is not possible to make excess risk adjusted returns. Those publications of non-random effects help the market to be more efficient. This can also explain the Market Crash of October 1987 and the Internet Bubble of the Late 1990s. As people now all notice that, even if it happens again, it would probably have low effect to the market. The market becomes more mature and efficient through these two cases.

Moreover, there are some cross-sectional predictable patterns, such as ÐŽ®Value Stocks appear to provide higher rates of return than stocks with high price-to-earnings ratiosЎЇ when accepting CAPM, Malkiel argues that the finding does not necessarily imply inefficiency of the financial market, it may only indicate failure of the CAPM to capture all dimensions of risk.

Finally, if the market is inefficient, the professional fund managers should be able to beat the market. However, the fact is that (even using data sets with some degree of survivorship bias), about 75% of actively managed funds have failed to beat the index from 1991 to 2001 by the Standard & PoorЎЇs 500 and the Wilshire stock indexes, and the similar results can be found for earlier decades.

In conclusion, Malkiel thinks that the financial market is remarkably efficient in its utilization of information in the long-term view. Although it is not perfectly efficient, as some exception happens sometimes such as the ÐŽ®Internet BubbleЎЇ in 1999, they are fortunately the exception and they can help the market be more efficient.

Answer to Question 3:

A) By examining B.G. MalkielЎЇs paper we know that Malkiel is definitely on the side of efficient market hypothesis by acknowledging the stock market is far more efficient and far less predictable. Efficient market hypothesis, associated with the idea of ÐŽ®random walkЎЇ which



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