CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction This chapter will address theories relevant to the behavior of financial markets and specifically stock prices movement on release of new information into the market, followed by the determinants of stock price, international and local empirical evidence and finally a summary of the chapter.
2.2 Theoretical Review
This section will review the theories that will guide the study and their relevance to the study. The theories to be reviewed include; Efficient Market Hypothesis (EMH), Random Walk Theory and Behavioral Finance Theory.
2.2.1 Efficient Market Hypothesis (EMH)
The EMH is a popular investment theory in Finance developed by Fama (1965). According to the EMH, an efficient capital market …show more content…
2.2.2 Random Walk Theory
The Random Walk Theory is an important model used in economics and finance in testing stock price behavior (Fama, 1965). A random walk simply means that successive stock price changes are independent of each other, that is, the future price of stocks is completely independent of past trends (Mbat, 2001).
Kendall (1950) initially put forward empirical support for the view that stock prices do not behave in a systematic manner but are more akin to a random walk. Foley (1991) supported Kendall’s argument. According to Lo and McKinley (1999), stock prices always fully reflect all the available information and no profit can be made from information based trading. This leads to a random walk where the more efficient the market, the more random the sequence of price …show more content…
Different scholars have given different definitions for behavioral finance. According to Shefrin (2001), behavioral finance is the study of how psychology affects financial decision making processes and financial markets. Sewell (2007) defined it as the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. It is of interest because it helps explain why and how markets might be inefficient. Behavioral finance is an attempt to explain and increase understanding of the reasoning patterns of investors, including the emotional processes involved and the degree to which they influence the decision-making process (Nyamolo,
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.
On the other hand behavioural finance defines the market dynamics and movement in terms of psychology of the participants in the trading process. Behavioural finance proposes that the amount of information available in the market regarding the factors that determine the output or profitability of a particular investment actually serve to determine the movement and output of the market itself (Fama, E.F., 1998).
As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the
Behavioral Finance is the new emerging science that explains the irrational behaviour of investors. Behavioral Finance unwind the usual assumption of traditional finance by incorporating systematic, observable and human departures from rationality into models of financial markets and behaviour. It helps us to understand the actual the behaviour of investors versus theories of investors’ behaviour.
In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another
Random walk hypothesis of the Asian stock markets (Malaysia and Korea) strongly rejected examined by Huang (1995). Gordon and Rittenberg (1995) examines weak form efficiency do not apply on Warsaw Stock Exchange as prices are not fully reflect the information. There is some evidence suggested by Gilmore and McManus (2003), random walk hypothesis is rejected by his finding in this study from 1995 to 2000. Moreover, Vosvorda et al. (1998) analyse the Prague Stock Exchange and the weak form market efficiency rejected by this study for 1995 to 1997. Dahel and Laabas (1999) studied the market efficiency of Saudi Arabia, Bahrain and Oman markets reject the weak form of the EMH. It has been reported that. Hasan et al. (2007) shows the evidence on Karachi Stock Exchange in Pakinstan walk as the behaviour of price do not supporting random thus are not weak form efficient. In the view of Dima and Milos (2009), the long term financial instability experienced within the Romanian economy, the market’s information is limited to a weak form
The premise of an efficient market is that stock prices adjust accordingly as information is received. The speed and accuracy of the pricing changes are a reflection of the strength of the market efficiency, where in theory a perfectly efficient market will re-adjust prices immediately and precisely with new information. The efficient market hypothesis aligns with beliefs about whether technical and fundamental analyses are useful in making investment decisions or whether a passive approach is appropriate. In a perfectly efficient market, these types of analyses are not able to predict stock price trends (based on market inefficiencies or price abnormalities) which could assist in portfolio positioning or investment management. However, some investors belive that the market pricing is not precise and that there are timing windows and pricing trends that can be identified through analysis of past performance and finding price abnormalities where all information is not correctly reflected in the stock price (Hirt, Block and Basu, 2006).
Under the idea that markets are efficient, stock prices reflect new information quickly and accurately. Furthermore, Morningstar (n.d.) contributes details on the strongest supportive theory of efficient markets, EMH exists in three forms: weak, semi-strong and strong. The hypothesis calls for the existence of informationally efficient markets, were current stock prices reflect all information, and attempts to outperform the market will only come in the form of riskier investments. Also, because of a large number of independent investors actively analyzing new information simultaneously as it enters the market, investors react accordingly and is immediately reflected in the stock
sider BACKGROUND Efficient market theory examines how accurately stock prices signal resource allocation alloc and fully reflect all available information. Fama (1970) introduced the efficient market hypothesis stating there are three forms of efficiency: weak, semi strong, and strong. A market semi-strong, that incorporates all historical information is said to be weak form efficient, while one that responds to all publicly available informatio is semi-strong efficient. In a semiinformation -strong efficient market, prices instantly change to reflect publicly available information. A strong form market, strong responds to all information, both public and private. The hypothesis claims that achieving above average returns on a risk adjusted basis is impossible (Fama 1970). (Fama, The lowest level of market efficiency, weak form, states that the market only reacts to historical information. This means that no one can earn above normal returns based on published historical information; however, the market does not quickly react to new public or private information. It may be possible then, in a weak form efficient market, to obtain abnormal returns form using either new publicly available or private insider information (Fama 1970). (Fama, A semi-strong form market is more efficient that a weak form, as it reacts to publicly strong available new information quickly and share prices adjust to reflect the market’s reaction. share Obtaining
The efficient-market hypothesis (EMH) is one of the well-known methods for measuring the future value of stock prices. According to this hypothesis, the market is efficient if its prices are formed on the basis of all disposable information. According to EMH if there is a possibility to predict the future price of shares, that is the first sign of an inefficient market.
When establishing financial prices, the market is usually deemed to be well-versed and clever. In a stock market, stocks are based on the information given and should be priced at the accurate level. In the past, this was supposed to be guaranteed by the accessibility of sufficient information from investors. However, as new information is given the prices would shift. “Free markets, so the hypothesis goes, could only be inefficient if investors ignored price sensitive data. Whoever used this data could make large profits and the market would readjust becoming efficient once again” (McMinn, 2007, ¶ 1). This paper will identify the different forms of EMH, sources supporting and refuting the EMH and finally
Efficient capital market “It was generally believed that securities markets were extremely efficient in reflecting information about the stock market as a whole” (Fama 1970). To extent that when there is new information about stock rise, the news was dispersed immediately and it affects the security 's price at that time.
The strong form of the EMH: Suggests that all information (public and private) is fully reflected in asset prices. This means that not even insider information can be used to beat the market. Therefore the only way to beat the market is by luck and chance only. It can be noted that all three versions of EMH indicate a role for passive management and no role for active management. As competition makes sure that any new information is reflected in stock prices.
Market efficiency requires that security prices react immediately in an unbiased way to the receipt of new information (Robert Shiller S1998). In other words, an efficient capital market is one in which stock prices fully reflect available information. In addition, there are three conditions for market efficiency; information flows freely, market is composed of rational investors where all competing against each other with the objective of maximizing wealth and there is no market imperfections. In efficient market, investors actively compete in the market based upon perceived mispricing derived from an analysis of
Key Words: Financial Momentum Effect, Momentum Strategy, Market Efficiency Hypothesis, Fama-French Three Factors Model, Behavioral Finance