Understanding the Efficient Market Hypothesis

The efficient market theory asserts that the stock market fully reflect all available information, therefore at any given time the market reflects all investors’ knowledge pertaining to that market. The efficient market hypothesis (EMH) explicitly states that it is impossible to beat the market because stock prices already incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value, meaning it is impossible for investors to either purchase or sell stocks for a profit. Much of the modern interpretation of the hypothesis is owed to the work of Fama and Samuelson from 1960s.

Fama et al. (1969) portrayed a stock market where all available information is reflected in its prices. Any newly disclosed information would cause an immediate reaction, and prices would be fully re-evaluated and adjusted to a new fair value that incorporate

Because of the unexpected element of the M&A announcement would cause the stock market to react by changing the prices of the affected stocks. According to the EMH, only the stock price of those firms engaging in M&A should see any response of the market, as all available information pertain to other the firms is considered to be unchanged and accessible for anyone and has already been reflected in their prices by the market. Since the unexpected part of the M&A announcement has hypothetically influenced the price, the returns of a stock surrounding this event is deemed not truly a historical reflection. These returns, termed abnormal return by FAMA (1969), can be used to explain the market’s expectation of an M&A, as well as to predict if the acquisition is going to be successful and profitable. Therefore, abnormal returns is the critical factor to determine the efficiency of a market, and to quantify the value creation effect of M&A based on investors’