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Efficient Market Hypothesis & Its Implications

For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is semistrong form but not strong form efficient, and (4) the market is strong form efficient.

a. The stock price has risen steadily each day for the past 30 days.

b. The financial statements for a company were released three days ago, and
you believe you've uncovered some anomalies in the company's inventory
and cost control reporting techniques that are causing the firm's true liquidity
strength to be understated.

c. You observe that the senior management of a company has been buying a lot
of the company's stock on the open market over the past week.

Solution Preview

According to Karz (2010) the efficient market hypothesis (EMH) states that at any given time security prices fully reflect all available information. According to this author, the implications of the efficient market hypothesis are truly profound: for example, most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. However, according to this author, if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

For example, Karz (2010) cites Fama who stated:

"That an efficient market is defined as a market where there are large numbers of rational,
profitmaximizers actively competing, with each trying to predict future market values of
individual securities, and where important current information is almost freely available to all
participants. In an efficient market, competition among the many intelligent participants leads
to a situation where, at any point in time, actual ...

Solution Summary

the purpose of this paper is to examine what is meant by the term "Efficient Market Hypothesis" and its implications both in the short and long term. For example, EMH implies that at any given time security and stock prices will fully reflect all available information in terms of the stock exchange. This paper discusses the notion, inherent in EMH, that if markets are efficient and current prices fully reflect all current information, then buying and selling securities in an attempt to outperform the market will be more a game of chance than anything else.

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