Insider Trading and Market Efficiency

Capital markets provide a function which facilitates the buying and selling of long-term financial securities to increase liquidity and their value, Watson & Head (2013). Hence, the Efficient Market Hypothesis (EMH) explains the relationship that exists with the prices of the capital market securities, where no individual can beat the market by regularly buying securities at a lower price than it should be. This means that in order to be an efficient market prices of securities will have to fairly and fully reflect all available information, Fama (1970). Consequently, Watson & Head (2013) believe that market efficiency refers to the speed and quality of how share price adjusts to new information. Nevertheless, the testing of the efficient markets has led to the recognition of three different forms of efficiency in which explains how information available is used within the market. In this essay, the EMH will be analysed; testing of EMH will show that the model does provide strong evidence to explain share behaviour but also anomalies will be discussed that refutes the EMH. Therefore, a judgment will be made to see which structure explains the efficient market and whether there are some implications with the EMH, as a whole.

It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).

It has been observed that companies tend to underperform when their insiders use trading plans to sell stock. New research also points to the conclusion that more aggressive plans are associated with the lowest performances. Gradient Analytics Inc., an independent research firm, followed insider sales of 30 companies and concluded that “aggressive” trading plans resulted in a 9.7% average underperformance in their companies’ stocks over 6 months. Insider-trading plans (also called 10b5-1 plans) are arrangements that allow the insiders of publicly traded companies to sell stocks they possess. To determine whether a trading plan can be considered “aggressive”, Gradient had specific measures. Gradient noticed in the summer of 2007 that Novatel Wireless Inc. executives had started selling through trading

Another concern relates of insider trading of market efficiency of stock market. In his classical study Fama (1970) proposes efficient market Hypothesis, which suggests that stock price reflects all available information (historical price, public and private) in

Table I Insider Trading Activity in Campbell Taggart from June 30 to August 2, 1982 The columns of the table give the date, the closing price of Campbell Taggart on the NYSE, the total daily trading volume of Campbell Taggart (in thousands of shares), the number of insider trades, the number of insiders who traded, and the total volume of shares purchased by insiders (in thousands), respectively. In all, the insiders bought shares in Campbell Taggart in 124 transactions, acquiring a total 265,600 shares over 23 trading days.

Efficient Market Hypothesis has been controversial issues among researcher for decades. Until now, there is no united conclusion whether capital markets are efficiency or not. In 1960s, Fama (1970) believed that market is very efficient despite there are some trivial contradicted tests. Until recently, both empirical and theatrical efficient market hypothesis was being disputed by behavior finance economist. They have found that investor have psychological biases and found evidences that some stocks outperform other stocks. Moreover, there are evidences prove that market are not efficient for instance financial crisis, stock market bubble, and some investor can earn abnormal return which happening regularly in stock markets all over the world. Therefore, the purpose of this essay is to demonstrate that Efficient Market Hypothesis in stock (capital) markets does not exist in the real world by proofing four outstanding unrealistic conditions that make market efficient: information is widely available and cost-free, investor are rational, independent and unbiased, There is no liquidity problem in stock market, and finally stock prices has no pattern.

The efficient market hypothesis theory states that it is impossible to “beat the market” because of the stock market efficiency causes the existing share prices to reflect all relevant information. Critically evaluate the above statement with reference to the three forms efficient market hypothesis.

The efficient market hypothesis (EMH) has consistently remained in the forefront of finance theory for decades. As technology has advanced, the ability to assess the efficient market hypothesis has increased exponentially and so have the opportunities to exploit it. Tactics such as high frequency trading and insider trading threaten the dependability of the efficient market hypothesis. EMH is a rudimentary theory that implies the value of an asset is directly correlated or about equal to the intrinsic value of the asset. (Brigham & Houston, 2012) The intrinsic value of a stock is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors (investopedia.com, 2014). Investors use this logic to determine whether to buy or sell a stock depending on its perceived value with respect to the intrinsic value. Whether the investor employs an active or passive investment strategy, the EMH is a rational decision making process to ensure a confident investment.

The efficient market hypothesis (EMH) has been the key proposition of traditional (neoclassical) finance for almost forty years. In his classic paper, Fama (1970) defined an efficient market as one in which “security prices always fully reflect the available information” [p.383]. In other words, if the EMH holds, the market always truly knows best. Until the mid-1980s the EMH turned into an enormous theoretical and empirical success. Academics from most prestigious universities and business schools developed

In article of 1971, Fama categorised market efficiency into three main forms. Weak form is based on the historical data of the stock prices. The semi-strong form tests how efficiently prices adapt to the publically available information. The third form is concerned whether any given market participants having monopolistic access to the creation of the stock prices.

Market efficiency tests include weak, semi-strong and strong three forms. They assume that financial markets are "informationally efficient", or that prices of trading assets, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. The weak form test is based on the past information and public available information for semi-strong while strong form covers not only the public but also the private information.

Fama(1970) presented 3 forms of market efficiency including weak form , semi- strong form and strong form. These forms represent respectively level of information that cannot be employed to give prediction on future prices ( past information, public information and private information ). At weak form of market efficiency, Fama argued that past data of stocks are almost useless to predict future prices of stocks. However, recent evidences have claimed that stock market was even inefficient at weak form. For example, the evidence of long term reversal presented by De bondt and Thaler (1985) ; relative strength of stock price discovered by Jagadeesh and Titman (1993) . These two paper has been considered to be the most compelling arguments against weak form of market efficiency.

In recent observation and research, the topic of corporate finance and the proposed ideas on how make them more efficient for professional has been established in each industry and explored further. In the research article, Whither Efficient Markets? Efficient Market Theory and Behavioral Finance (2010), expands on the research proposed that issues in the measurements of markets and theories surrounding behavioral finance can be addressed through policy and proper finance knowledge. The strategy or methodology in which the author illustrates is experimental and expected cause and effect relationship. The supported evidence used in the testing gave background to the subtopic and conclusion question illustrated in week 8. The author used several studies from past industries and decades to illustrate ethical behavior behind investment and the changes in prices. ‘The theory that stock prices instantaneously adjust to reflect new information leads to the view that stock prices are unpredictable and follow a random walk. “If the flow of information is unimpeded and immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today (2010). This article contributes to research observed and adds key information to the hypothesis.

The EMH supposes that the capital market should be a level game for all players. Herein, all information consequential to an investor’s decision is incorporated in determination and fixation of share prices. This is irrespective of whether it has been made public or not, as long as any single investor is aware of its existence. As such there is no chance of overpricing or underprizing of shares (Gili, Cheng-few & Basin 2008). With any new information, the change is instantly effected. Prediction, according to the premise, is a mere episode of chance. Today, some of the world’s business moguls have seemingly done the impossible by overtaking the market alteration. This has made them reap great benefits from capital market trading and obviously evoked doubts on the authenticity of this proposition.

The efficient market hypothesis (EMH) promoted by Fama (1970) is considered an important theory in financial area. However, the existence of momentum profits has threatened EMH.