Efficient Trading Market.docxVIP

/essays/finance/efficient-trading-market.php Efficient Trading MarketOne of the most renowned concepts of modern portfolio theory is the Efficient Market Hypothesis. According to the EMH,“capital markets are efficient in an informational sense. A capital market is considered to be efficient if, through trading activities, investors set the price of any particular security in a manner that impounds new information about that security in a direct way”(Financial Advisor Magazine, 2004).This implies that a market is informationally efficient when current prices reflect all past and currently available information. Hence, the market price of a security can only be altered if new information, which by definition is not fully foreseeable, appears. Most importantly, the EMH presupposes that investors are rational and therefore value securities rationally. When new information comes out, investors evaluate its effect on current and future cash flows, and adjust the price of the stock to reflect the new information.However, there are some challenges to the EMH which have been extensively documented. The two most broadly known and extensively studied are contrarian and momentum trading strategies, which presume that future returns are predictable on the basis of past returns. Momentum strategies buy stocks which have performed well in the past (winners) and sell stocks which have performed poorly in the past (losers), profiting from return continuation.Contrarian trading strategies support the opposite method of buying past winners and selling past losers, thus generating profits from return reversals. Both these strategies, when properly carried out have been shown to generate exceptional returns. Contrarian strategies are found to be profitable at very short time horizons up to approximately one month and at long horizons of several years, whereas momentum strategies are found to be profitable at intermediate horizons of up to one year.2. Literature Review2.1 Momentum strate