Question

Supply and demand - The Efficient Market Hypothesis

Case study question

The efficient market hypothesis is an extension of the supply and demand model.

Required:

a. Discuss the assumptions of the supply and demand model inherent in the Efficient Market Hypothesis (EMH).

b. Why is the securities market viewed as a good example of the supply and demand model?

c. Discuss the three forms of the EMH.

Answer 1

The EMH theory is an investment theory that says that the stock market price is always efficient. By efficient, it is meant that the price at which shares are traded in the market is always inclusive and reflective of the market information. Thus, it is impossible for any investor to make super-profit either by selling stocks at an inflated price or by purchasing stocks at a reduced price. The only way out to make super-profit is to buy risky share.

A. Followings are the assumptions of demand and supply model inherited in EMH:

• The market/ economy has the complete information.
• Prices are always adjusted of the market information.
• there are no artificial restrictions on supply and demand.

B. Demand and supply always adjust with the new market information. just like them, in the securities market, the stock exchanges reflect a relatively competent distribution system and the information is available from many outlets (Schroeder, 2011).It is considered efficient if it reflects all available information and reacts immediately to new information.

C. The EMH can be categorized into three forms:

• Weak Form EMH: Suggests that all past information is priced into securities. Fundamental analysis of securities can provide an investor with information to produce returns above market averages in the short term but there are no "patterns" that exist. Therefore fundamental analysis does not provide long-term advantage and technical analysis will not work.
• Semi-Strong Form EMH: Implies that neither fundamental analysis nor technical analysis can provide an advantage for an investor and that new information is instantly priced in to securities.
• Strong Form EMH: Says that all information, both public and private, is priced into stocks and that no investor can gain advantage over the market as a whole. Strong Form EMH does not say some investors or money managers are incapable of capturing abnormally high returns but that there are always outliers included in the averages.