**2. Efficient market hypothesis**

Efficient market hypothesis states that prices of financial assets reflect all information that is available [6]. Although the idea goes all the way back to Bachelier (1900), its development can be pointed mainly to two scientists, Paul A. Samuelson and Eugene F. Fama, who have independently made leading contributions in the 1960s [2]. Samuelson's focus was on temporal pricing models of storable commodities, mechanics of pricing and linear-programming solutions. He stated that if prices contain all the relevant information and participant expectations, then they could not be forecasted [7]. On the other hand, Fama focused more on the measurement of statistical properties of stock prices as well as technical and fundamental analyses, which will be discussed in the last section of the chapter. Fama was the first researcher to use the term 'efficient market' [3] and briefly explained it as 'prices fully reflect all available information' [8–10].

According to EMH, predicting the change in prices and turning them into profit are near impossible and highly unlikely. What drives these changes in price is the new information that is arriving. A particular market, under the theory, can be deemed as efficient if stock prices immediately react to this new-coming information. The information coming in must be unpredictable, by definition, because if future information can be predicted now, then this information would be reflected in today's prices and not in future prices. Adjustment of stock prices to its fair market value in reaction to the new information will cause them to either increase or decrease. It will hence make the stock price movements random and unpredictable [11]. This is also referred to as a **Random Walk Hypothesis**.

The idea of a 'random walk' is closely related to the EMH as it is a financial theory and focuses on investments and claims that present-day stock prices increase or decrease, and this happens randomly and has nothing to do with past stock prices. Thus, the idea is that prices immediately capture the information as was said by the EMH. In this situation, even the most inexperienced investor will obtain a rate of return similar to that of his experienced colleagues [12]. Investors have no chance of achieving gains in these markets without taking on themselves many additional risks. The higher the gains, the higher the risk will be [3, 13].

Therefore, it could easily be said that studying past stock prices (technical analysis) or analysing company's financial information (fundamental analysis) would not benefit the investor. This is important in the case of investors as they look for securities that are undervalued, ones they predict to increase in value in the future. For them the higher the gains, the better it is. However, as we have mentioned, EMH shows that no profits can be made if the market is found efficient because the information about the price changes already would have been captured [12, 14]. But what happens if the market is found to be inefficient? This makes markets in emerging economies more attractive as majority of previously conducted research shows that these stock markets do not follow a random walk and are not efficient [15–20]. The absence of a random walk will mean the inappropriate pricing of stocks away from the fair value and higher risk. This can lead investors to predict future stock prices and gain higher returns [3]. It is expected that stock prices in these markets will increase more than the others because capital allocation in the economy is distorted and the overall economic development of the market is affected [21].

#### **2.1. Principles of EMH**

used to refer to a situation where the quantity produced is at such a level that the more you produce from this point onwards it will lead to a fewer productions of the other. In a similar context, one can also think of Pareto efficiency: distribution or resources to make one better

When analysing financial markets, whether these markets are from a developed or from an emerging economy, the term 'efficiency' refers to the informational efficiency of the market, which is about the degree of information reflected in the prices of financial assets [2]. It reflects how the financial asset prices adapt to the incoming information. The quicker it reflects the more informational efficient the market will be, making it hard for these investors to beat the

In this chapter, we will be explaining the efficient market hypothesis (EMH), which is the main theory behind information efficiency; relevant definitions will be given and the different forms of efficiencies will be identified using previous studies. Possible anomalies will also be talked about. The chapter will end with a discussion on the technical and fundamental analysis in the usage of efficient market hypothesis as the basis of investment policies and an application part, where the stock market prices of the 24 identified emerging economies of the world are analysed using an augmented Dickey-Fuller (ADF) test to observe whether they contain a unit root or not. All of these parts will be explained in relation to information efficiency of emerging economies. There are specific characteristics of these markets that make them attractive for analysis and for investors, such as lower than average income per capita, high volatility, rapid growth, higher than the average return and less-mature capital markets [5]. These characteristics which make emerging economies unique in the study of market efficiency will also be incorporated

Efficient market hypothesis states that prices of financial assets reflect all information that is available [6]. Although the idea goes all the way back to Bachelier (1900), its development can be pointed mainly to two scientists, Paul A. Samuelson and Eugene F. Fama, who have independently made leading contributions in the 1960s [2]. Samuelson's focus was on temporal pricing models of storable commodities, mechanics of pricing and linear-programming solutions. He stated that if prices contain all the relevant information and participant expectations, then they could not be forecasted [7]. On the other hand, Fama focused more on the measurement of statistical properties of stock prices as well as technical and fundamental analyses, which will be discussed in the last section of the chapter. Fama was the first researcher to use the term 'efficient market' [3] and briefly explained it as 'prices fully reflect

According to EMH, predicting the change in prices and turning them into profit are near impossible and highly unlikely. What drives these changes in price is the new information

off but at the expense of another [1].

50 Financial Management from an Emerging Market Perspective

market [3, 4].

within the chapter.

**2. Efficient market hypothesis**

all available information' [8–10].

If we want to shortly summarise the points mentioned above, we can say the following as the basic characteristics of an efficient market [22] under the efficient market hypothesis:


#### **2.2. Forms of efficiency**

#### *2.2.1. Weak form of market efficiency*

Weak form of market efficiency involves past information and past prices. According to the weak form of efficiency under the EMH, current stock prices fully reflect all of the available past information [11]. All other information such as profit forecasts or announcements of mergers and so on will not have any effect on the current stock prices [13]. This means that no one can analyse past prices of stocks and be able to beat the market.

Under the EMH, there is a reason that this form is named 'weak'. The strength of the efficiency, i.e. degree of weakness, symbolises the type of information available. Historical information plus information on stock prices can be classified as the most easily obtained and costless information. Therefore, it is classified as weak in the efficiency scale by Fama in the EMH [10]. In the weak form of efficiency, investors cannot make a profit from using information that everyone knows [14].

#### *2.2.2. Semi-strong form of market efficiency*

In the semi-strong form of efficiency, besides the past information, all the publicly known and available information are also reflected on the price of the financial assets/stocks. This can be the quality information, financial statements, patents as well as information provided by media, investment advisors, annual reports and other information that can be publicly accessible. An important point to note here is that public information does not have to be just financial information [13]. To give an example, consider the cosmetics industry. When analysing cosmetics companies, the relevant information can be the new, published research regarding cosmetics testing.

From the moment these public information that are mentioned above are published, prices of financial assets will immediately adjust itself to become higher or lower according to the nature of the information. Then, it can be deduced that if all investors have access these publicly information, then none of them have an advantage over the other. Therefore, they cannot make excess profit by using a fundamental analysis [11].

Semi-strong and weak forms of market efficiency can be related to each other as the weak form includes past and the semi-strong form includes both past and the public information. It can be deduced that, if one market is found to be efficient in the semi-strong form, then it also must be efficient in the weak form [13].

#### *2.2.3. Strong form of market efficiency*

This can be said to be as the strictest version of market efficiency because it not only contains the past and public information but also involves private information. Private information in studies can also be referred to as the inside or insider information. According to the EMH, the strong form of market efficiency can be defined as a market where the prices of financial assets reflect all of the available public and private information. In other words, stock prices in this market reflect all information that exists [23].

If a market is efficient in the strong form, it leaves no room for investors or even insiders from generating profits using information that is not publicly known. For example, let us take the cosmetics company to analyse once more; imagine that its research and development department came up with a breakthrough and they know that this piece of information will cause the company shares to increase by a large amount in the near future. By the time one of the members of this R&D team goes out and buys few of the company's stocks, if strong form of efficiency holds, this information would have already been reflected on the stock price. Hence, that person with insider information would not be able to use this for his/her benefit [11, 13].

It is debateable whether the strong form of market efficiency even exists. The results are contradicting, and research points out that evidence regarding the strong form is inconsistent. Some argue that it is quite impossible for an insider not to benefit from the private information they hold. But, some argue that there is no possibility of keeping secrets. Most countries, today, have certain laws and regulations to prevent insider trading such as the establishment of the Securities and Exchange Commission in the USA. This commission requires owners, directors or corporate officers to report to them in order to limit their harmful activities [23].

#### *2.2.4. Inefficient markets*

**2.2. Forms of efficiency**

*2.2.1. Weak form of market efficiency*

52 Financial Management from an Emerging Market Perspective

tion that everyone knows [14].

regarding cosmetics testing.

*2.2.2. Semi-strong form of market efficiency*

make excess profit by using a fundamental analysis [11].

must be efficient in the weak form [13].

market reflect all information that exists [23].

*2.2.3. Strong form of market efficiency*

Weak form of market efficiency involves past information and past prices. According to the weak form of efficiency under the EMH, current stock prices fully reflect all of the available past information [11]. All other information such as profit forecasts or announcements of mergers and so on will not have any effect on the current stock prices [13]. This means that no

Under the EMH, there is a reason that this form is named 'weak'. The strength of the efficiency, i.e. degree of weakness, symbolises the type of information available. Historical information plus information on stock prices can be classified as the most easily obtained and costless information. Therefore, it is classified as weak in the efficiency scale by Fama in the EMH [10]. In the weak form of efficiency, investors cannot make a profit from using informa-

In the semi-strong form of efficiency, besides the past information, all the publicly known and available information are also reflected on the price of the financial assets/stocks. This can be the quality information, financial statements, patents as well as information provided by media, investment advisors, annual reports and other information that can be publicly accessible. An important point to note here is that public information does not have to be just financial information [13]. To give an example, consider the cosmetics industry. When analysing cosmetics companies, the relevant information can be the new, published research

From the moment these public information that are mentioned above are published, prices of financial assets will immediately adjust itself to become higher or lower according to the nature of the information. Then, it can be deduced that if all investors have access these publicly information, then none of them have an advantage over the other. Therefore, they cannot

Semi-strong and weak forms of market efficiency can be related to each other as the weak form includes past and the semi-strong form includes both past and the public information. It can be deduced that, if one market is found to be efficient in the semi-strong form, then it also

This can be said to be as the strictest version of market efficiency because it not only contains the past and public information but also involves private information. Private information in studies can also be referred to as the inside or insider information. According to the EMH, the strong form of market efficiency can be defined as a market where the prices of financial assets reflect all of the available public and private information. In other words, stock prices in this

one can analyse past prices of stocks and be able to beat the market.

Efficient market hypothesis classifies efficiency into three categories as previously explained. However, when the subject is emerging economies, it would not be correct if we neglect one more important situation: when a market is not found efficient in any of these three forms. We can refer to these markets as **inefficient markets**. Inefficiency, neglecting the random walk, is not a desirable situation. Recent studies point out different techniques to try and solve any mis-assessments. There are studies which show that some markets are inefficient and do not fall under any of the efficiency forms, and the majority of these were observed as to be either developing, emerging or transition economies [15–17]. This will be further mentioned in the following section.

Study conducted by Grossman and Stiglitz argues that it is quite impossible for markets to be perfectly efficient as there will be no reason left for investors to trade in these markets if there were no profits to be made [24]. However, this is a serious situation as, in the long run, it will lead to the collapse of these markets. Also, we all know that trading stocks incur costs, so it is important whether the gains made is sufficient enough to compensate for these costs. This is another question that needs to be kept in mind regarding inefficiencies [7].

#### **2.3. EMH and emerging economies**

There are varieties of definitions of emerging economies, but we must be careful in defining it correctly. First of all, a country is classified as emerging when its GDP per capita decreases under a certain level [25]. Then, generally there is low income, frequent economic and political change and rapid growth in these countries. Some other characteristics include high volatility, higher than average return and being less mature capital markets [5]. There is a reason why these countries are named emerging as the basic principle behind them indicates that they try to 'emerge' from their current underdeveloped position and move towards being part of the developed countries, the process which is called **convergence** [25].

Emerging economies can be divided into two groups: developing and transition economies. Transition economies are countries with economies moving towards a market economy from the existing centrally planned economy, such as the Former Soviet Union and China. Developing economies, on the other hand, are countries with economies that are growing and are in the process of becoming industrialised, such as Turkey, Poland, Indonesia, Bangladesh and many more [26].

Especially in the last couple of decades, research on the emerging economies around the world started gaining importance. The reason for this can be attributed to few different factors. Firstly, countries with emerging economies are highly populated and make up a great portion of the world's population as well as land. Secondly, growth in these countries is far more than its developed counterparts. They are beginning to be seen as having diverse environments, whether it is the business, cultural, economic, legal financial or political environments. Researchers want to focus on these diverse environments; analyse, assess and come up with new theories and evidence to understand; and, therefore, improve the welfare of these countries [5]. Application of the EMH is one of them.

It is clear why we keep on stressing the importance of studies conducted on emerging markets in each section. There is an ocean full of information that is yet to be discovered. We can also consider the effects of pull and push factors in the increasing importance. Lack of opportunities and lower returns for investments make up the push factors which are associated with developed stock markets. It pushes investment towards emerging economies. On the other hand, emerging economies tend to have pull factors which attracts these investments. These are reforms (structural and economic), international equity offerings and exchangerate stabilisation programmes [27].

History is an important concept when assessing market data and the EMH. There needs to be sufficient data in order for us to be able to analyse the efficiency of these stock markets. But the problem with emerging economies is that they are relatively new markets and have very little data. This makes it difficult to obtain healthy results and maybe one of the reasons that majority of these results come up as inefficient. Evidence shows that stock prices take its time when adjusting to information; it may be much better to look over a longer time period in order to obtain results of whether these markets are efficient or not rather than focusing on the short run [28].

#### *2.3.1. Reviewing past research*

EMH has made tremendous contribution to the area of finance in the past few decades. Among the three forms of market efficiency, probably the weak form is the most commonly tested form. We can see that research on emerging economies (including developed and transition economies) mainly focuses on the weak form and in some the semi-strong form [29]. Strong form of market efficiency is very difficult to test [23], and there is hardly any evidence of its test on emerging economies. In emerging economies, returns of stocks are said to be highly predictable and the stock markets less efficient than those of emerging economies [30].

For example, Lee et al. investigated the efficiencies of 26 developing countries using panel data stationarity tests between 1999 and 2007, which showed inefficiency of these markets [31]. Kim and Shamsuddin looked at the weak form of efficiency of a group of Asian stock markets using both daily and weekly data from 1990 to 2005. They have found that stock markets in Hong Kong, Japan, Korea, Singapore and Taiwan were efficient in the weak form. But stock markets in Indonesia, Malaysia and the Philippines were found to be inefficient [32]. It is interesting as Korean stock market has been tested for weak form of efficiency by others and found inefficient [15–17]. Istanbul Stock Exchange [currently called Borsa Istanbul (BIST)] was tested for the weak form of efficiency by many and was also found both efficient [30, 33, 34] and inefficient [18–20].

It is important to remember that the data presented in this chapter on the efficiency of emerging economies comprises only an extremely small sample of the entire population of studies. Therefore, we can say that there are many studies, with many different results. The results can show variations among each other, where a study can indicate efficiency, whereas the other shows inefficiency. The reason can be attributed to data being collected from different time periods, whether daily, weekly or monthly data that is being used, or even can be due to the tests that are used. Only recently, studies have pointed out that nonlinearity in stock prices is very important and that they should be taken into account in the tests to prevent the misleading results [35].

#### *2.3.2. Emerging economies and liberalization*

they try to 'emerge' from their current underdeveloped position and move towards being part

Emerging economies can be divided into two groups: developing and transition economies. Transition economies are countries with economies moving towards a market economy from the existing centrally planned economy, such as the Former Soviet Union and China. Developing economies, on the other hand, are countries with economies that are growing and are in the process of becoming industrialised, such as Turkey, Poland, Indonesia, Bangladesh

Especially in the last couple of decades, research on the emerging economies around the world started gaining importance. The reason for this can be attributed to few different factors. Firstly, countries with emerging economies are highly populated and make up a great portion of the world's population as well as land. Secondly, growth in these countries is far more than its developed counterparts. They are beginning to be seen as having diverse environments, whether it is the business, cultural, economic, legal financial or political environments. Researchers want to focus on these diverse environments; analyse, assess and come up with new theories and evidence to understand; and, therefore, improve the

It is clear why we keep on stressing the importance of studies conducted on emerging markets in each section. There is an ocean full of information that is yet to be discovered. We can also consider the effects of pull and push factors in the increasing importance. Lack of opportunities and lower returns for investments make up the push factors which are associated with developed stock markets. It pushes investment towards emerging economies. On the other hand, emerging economies tend to have pull factors which attracts these investments. These are reforms (structural and economic), international equity offerings and exchange-

History is an important concept when assessing market data and the EMH. There needs to be sufficient data in order for us to be able to analyse the efficiency of these stock markets. But the problem with emerging economies is that they are relatively new markets and have very little data. This makes it difficult to obtain healthy results and maybe one of the reasons that majority of these results come up as inefficient. Evidence shows that stock prices take its time when adjusting to information; it may be much better to look over a longer time period in order to obtain results of whether these markets are efficient or not rather than focusing on the short run [28].

EMH has made tremendous contribution to the area of finance in the past few decades. Among the three forms of market efficiency, probably the weak form is the most commonly tested form. We can see that research on emerging economies (including developed and transition economies) mainly focuses on the weak form and in some the semi-strong form [29]. Strong form of market efficiency is very difficult to test [23], and there is hardly any evidence of its test on emerging economies. In emerging economies, returns of stocks are said to be highly predictable and the stock markets less efficient than those of emerging economies [30].

of the developed countries, the process which is called **convergence** [25].

54 Financial Management from an Emerging Market Perspective

welfare of these countries [5]. Application of the EMH is one of them.

and many more [26].

rate stabilisation programmes [27].

*2.3.1. Reviewing past research*

Liberalization can be defined as a decision made by governments to increase foreign investment and trade. Its aim is for the removal of barriers, lessening of regulations and government controls towards foreigners giving them the right to purchase shares and trade within that country. It is crucial that the impact of liberalization be measured and assessed because it results in both financial and economic changes within the market [36]. To gain the benefits of liberalization, from the second half of the 80s onwards, countries with emerging economies started modifying their laws and allowed foreigners into their markets. The changes of financial liberalization in these emerging economies have been great and led researchers' interest to the area [37].

Some of the research on the liberalization of emerging economies looked at the issue of efficiency of their stock markets. Their point was that if these markets are being opened to foreign investment, are they now more efficient? [38]. According to the EMH, the market's efficiency increases as it becomes more liberalized because liberalization means the market will be made open to the public [37]. Although theoretically true, the effect of liberalization on the efficiency of emerging country's stock market should be further investigated.

#### *2.3.3. Emerging economies and financial crisis*

One more topic that must be mentioned under emerging economies and EMH is the effect of a financial crisis or a crash of a market to the efficiency of the stock market of that particular country. Financial crisis is counted by researchers as the possible factor of inefficiency. But, yet again, there is not much evidence yet to fully support this theory. A study conducted by Garas and Argyrakis showed a relationship between financial crisis and market efficiency. They have looked at the Athens Stock Exchange stock prices between the years 1987 and 2004 and concluded that during the crisis, the stock market became less efficient, i.e. market showed lower efficiency [39]. However, at the same time, Hoque et al. looked at pre- and postcrisis periods and pointed out that there was no relationship between the crisis and market efficiency [40]. Therefore, it is an area that can be exploited in the near future.
