Are Australian Stock Markets Efficient sample essay
The Efficient Market Hypothesis (EMH) was developed by Professor Eugene Fama at the University Of Chicago Graduate School Of Business. The basic concept of market efficiency is that a market is efficient when current prices are representative of all the information about a security which is available to the public.
He described an efficient market in his famous work, “Efficient Capital Markets: A Review of Theory and Empirical Work” as “a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information.
A market in which prices always “fully reflect” available information is called “efficient. In this essay, we attempt to analyze the Australian Stock Exchange in the context of the EMH and find out if it is efficient or not. The paper starts by introducing the EMH and the Australian Stock Exchange and then identifying if the EMH is applicable or not. The Efficient Market Hypothesis: The EMH states that constantly being ahead of the market and outperforming it by employing information that is already common in the market is not possible, except if one counts sheer luck to be the determinant of this outcome.
In the context of the EMH, information refers to anything which can have an impact in prices, that is not and can not be known in the present, but appears suddenly later on. One of the requirements of the EMH is that agents have rational expectations: agents’ expectations are correct on average, and expectations are upgraded to include any new, relevant information as soon as they get to know about it. This is different from the requirement that agents act rationally, this is about rational expectations.
Simply, EMH warrants that the reactions of investors to new information are random, instantaneous and unbiased, and assume a normal distribution pattern, because of which the net impact on market prices can not be exploited to reap a massive profit, and old information cannot be used to predict future changes in price. There exist three versions of the EMH, which are distinguished on the basis of the level of information available, and have different implications for the operations of the markets.
They are: weak form efficiency, semi-strong form efficiency and strong form efficiency. In weak-form efficiency, the current prices of assets are representative of the past information about price and volume. It is given the name of weak form because in such a market, the security prices are very easily available for public access, and are the best and most unbiased reflection of the value of the security. In this state of the market, the general implication is that it will not be possible for any one person to outperform the market since everyone is privy to the same information.
However, proponents of weak form efficiency assert that fundamental analysis can be a useful resource to find out which stocks are under- and over-valued. Yet, this does not deter financial analysts from studying the sequence of prices and trade volume information from the past to try and generate excess returns. This research is known as technical analysis, and the EMH pronounces it a useless method for foretelling future changes in price and thus, consistently producing profits.
The semi strong form of EMH affirms that asset prices are reflective of all publicly available information. In this context, publicly available information is inclusive of not just historical price data, but also of information from the financial statements of the company, announcements and press releases, economic factors and other information. Here as well, the general implication is that it will not be possible for any one person to outperform the market since everyone knows the same information.
Additionally, changes in share prices occur within a very small time frame and in an unbiased way whenever new information is publicly available, hence, this information can not be used to earn excess returns. Unlike the weak-form EMH, advocates of semi strong EMH state that fundamental analysis will not be of any use in attempting to generate profits as they will not facilitate the forecasting of future price changes. The strong form of EMH states that all information, public, private or even insider information, is instantaneously reflected in current share prices and hence, no one can use this information to earn abnormal returns.
This means that insider trading will not be able to result in gains even if the information is for example, of a takeover which has been finalized mere minutes earlier. To justify this, proponents of this form support their theory by stating that market’s expectation of future development lacks bias, and hence incorporates information into share price in a more objective manner than insiders. The EMH has advocates and critics like.
Its proponents believe that markets can be efficient even if a large number of market participants are irrational and even is stock prices reflect a higher volatility level than can be attributed to factors such as earnings and dividends. Their belief in efficiency is strong simply because they “view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above-average risk adjusted returns. ”
Critics however argue about the efficacy about the theory when according to them, there exist some obvious reasons for inefficiency such as the longer time frame that is required for diffusion of information than proposed by the EMH, and hence lack of instantaneous incorporation into share prices, the clout which some market participants have and employ, such as financial institutions and the inherent expertise of participants such as the sophisticated professional investors. The Australian Stock Exchange: The Australian Stock Exchange – commonly referred to as the ASX – is a publicly listed exchange formed in the year 1987.
It was constituted through the amalgamation of six independent stock exchanges located in the state capitals of each of Australia’s states and is “co-regulated” by the Australian Securities and Investments Commission. The major stocks traded in ASX include BHP Billiton, Commonwealth bank of Australia, Telstra Corporation, Rio Tinto, National Australia Bank and Australia and New Zealand banking group. These stocks are the biggest vis-a-vis market capitalization in the ASX. Figures at March 30, 2007 showed that there were 2014 stocks listed on the ASX, and total market capitalization was AU$1. 39 trillion.
Efficiency and the ASX: When aggregate share price index data (from the period 1975-92) was used to conduct tests of both weak and semi-strong forms of the EMH for Australia, it was found that past returns did have predictive power for current returns, which is inconsistent with the weak EMH. However, the degree of predictability was low, the results were robust, but the correlation was stronger in daily data as compared to weekly and monthly returns, and was visibly lesser in the latter part of the sample period of this study. For testing semi-strong efficiency, the researcher used the techniques of cointegration and Granger causality.
Findings regarding cointegration were in line with market efficiency as it was found that the indexes of Australia and New Zealand were not cointegrated, in scenarios of daily, weekly and monthly data. There was predictability of results, but similar to the test for weak form, the degree of this was small. Hence, according to this particular research, for the most part, future returns could not be gauged from past trends in stock prices. Another study attempted to ascertain whether stock prices for Australia were consistent with the EMH by finding out whether they could be characterized by a unit root.
If they can be, then this means that returns of its stock market can not be predicted from previous changes in price, which satisfies the premise of the EMH. Monthly data was used of the country’s stock price index, ASX All Ordinaries, over the period 1964:06 to 2003:04. It was found that Australian stock prices were characterized by a unit root, which means that the efficient market hypothesis was very much applicable to this market, as returns could not be forecasted using data of previous price changes.
A contribution to the empirical literature on market efficiency was made by Nicolaas Groenewold and Kuay Chin Kang when they tested the Australian share market for weak (which is a necessary condition for semi strong) and semi strong efficiency using data from the 1980s. They tested the latter using macro data such as inflation, the money stock, exchange rates etc as opposed to other studies which employed micro data such as company-specific announcements. None of the three tests of weak efficiency led to the rejection of the weak EMH and therefore could not debar the semi strong tests.
Data was consistent with semi-strong efficiency and the researchers concluded that their results “support market efficiency in the sense that lagged returns or lagged values of the unexpected values of explanatory variables have no significant joint explanatory power in regressions for share returns although an occasional individual term was significant. ” Another study used takeover bids as a source of information (since takeovers are frequent and significant events in Australia) and studied the adjustment of Australian share prices to this information source in the context of the EMH.
Its data set consisted of all 572 takeover bids for more than 50% of the outstanding ordinary shares of the offeree, which was an Australian listed company, made between 1 January 1966 and 31 December 1972, and weekly closing share prices for all firms involved in successful and unsuccessful bids from 1 January 1964 and 31 December 1974. Similar to the study mentioned above, it also found the Australian share market to be semi strong efficient as advocated by the pioneer of Eugene Fama, i. e. , “information made public during takeover negotiations is rapidly and without bias incorporated into share prices”.
A research paper which analyzed the validity of two classes of simple technical trading rules in the ASX used standard t-tests and bootstrap methods on data from 1 January 1980 to 31 December 2002 also found that the ASX was “informationally efficient” and particularly in the period after 1991, had become more efficient than in the period before. To ensure valid and stable results, tests were conducted on the full sample, as well as on four non-overlapping sub-samples which were representative of a different stage in the development of the Australian financial economy.
The full sample showed some evidence of predictability but the sub-sample tests reflected a complete loss of predictive power of all technical rules examined, and especially so after 1991. Hence, this study concluded that the usefulness of technical trading rules as forecasting tools for the investor declined as the efficiency of the ASX increased in the latter part of the sample period. Conclusion: The efficient market hypothesis has been hotly debated and a body of evidence has been developed that supports it.
Yet, there is also ample research which explores situations and factors which render this a naive theoretical concept, with rare applicative value in today’s complex financial world. However, most research on the Australian stock market has found that it is an efficient market where conditions for the EMH were tested and results showed the market to be consistent with weak form and semi strong efficiency. This has important implications for investors as well as financial managers as it shows that in most scenarios, stocks are fairly valued.
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