Market Efficiency

EFFICIENT
FINANCIAL
MARKETS
What Is Market Efficiency?
■ Market efficiency refers to the degree to which market prices reflect all available,
relevant information. If markets are efficient, then all information is already
incorporated into prices, and so there is no way to "beat" the market because there are
no undervalued or overvalued securities available.
■ The term was taken from a paper written in 1970 by economist Eugene Fama, however
Fama himself acknowledges that the term is a bit misleading because no one has a clear
definition of how to perfectly define or precisely measure this thing called market
efficiency. Despite such limitations, the term is used in referring to what Fama is best
known for, the efficient market hypothesis (EMH).
• The EMH states that an investor can't outperform the market, and that market anomalies
should not exist because they will immediately be arbitraged away. Fama later won the Nobel
Prize for his efforts. Investors who agree with this theory tend to buy index funds that track
overall market performance and are proponents of passive portfolio management.
• New information can result in a change in the intrinsic value of a security, but subsequent
security price movements will not follow any predictable pattern, so that one cannot use past
security prices to predict future prices in such a way as to profit on average. Moreover, close
attention to news releases will be for naught. Alas, by the time you are able to take action,
security price adjustments already will have occurred, according to the efficient market
notion. Unless they are lucky, investors will on average earn a “normal” or “expected” rate of
return given the level of risk assumed.
 Market efficiency refers to how well current prices reflect all available, relevant
information about the actual value of the underlying assets.
 A truly efficient market eliminates the possibility of beating the market, because any
information available to any trader is already incorporated into the market price.
 As the quality and amount of information increases, the market becomes more efficient
reducing opportunities for arbitrage and above market returns.
Three Forms of Market Efficiency
■ Weak Form Efficiency
■ Semi strong form Efficiency
■ Strong form Efficiency

Weak Form Efficiency
■ In the weak-form efficient market hypothesis, all historical prices of securities have
already been reflected in the market prices of securities. In other words, technicians –
those trading on analysis of historical trading information – should earn no abnormal
returns. 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 Efficiency
■ The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb
new public information so that an investor cannot benefit over and above the market by
trading on that new information. This implies that neither technical analysis nor
fundamental analysis would be reliable strategies to achieve superior returns, because
any information gained through fundamental analysis will already be available and thus
already incorporated into current prices. Only private information unavailable to the
market at large will be useful to gain an advantage in trading, and only to those who
possess the information before the rest of the market does.

Strong form Efficiency
■ The strong form of market efficiency says that market prices reflect all information both
public and private, building on and incorporating the weak form and the semi-strong
form. Given the assumption that stock prices reflect all information (public as well as
private), no investor, including a corporate insider, would be able to profit above the
average investor even if he were privy to new insider information.

Alternative Efficient Market Hypotheses
 An article by Fama (1970) attempted to formalize the theory and organize the growing
empirical evidence. Fama presented the efficient market theory in terms of a fair game
model, contending that investors can be confident that a current market price fully
reflects all available information about a security and, therefore, the expected return
based upon this price is consistent with its risk.
 In a subsequent review article, Fama (1991a) again divided the empirical results into
three groups but shifted empirical results between the prior categories.
 Therefore, the following discussion uses the original categories, noted above, but
organizes the presentation of results using the new categories.
Weak-Form Efficient Market Hypothesis
 The weak-form EMH assumes that current stock prices fully reflect all security market
information, including the historical sequence of prices, rates of return, trading volume
data, and other market-generated information, such as odd-lot transactions and
transactions by market-makers. Because it assumes that current market prices already
reflect all past returns and any other security market information, this hypothesis
implies that past rates of return and other historical market data should have no
relationship with future rates of return (that is, rates of return should be independent).
Therefore, this hypothesis contends that you should gain little from using any trading
rule which indicates that you should buy or sell a security based on past rates of return
or any other past security market data.
Semi-strong Form Efficient Market
Hypothesis
 The semi-strong form EMH asserts that security prices adjust rapidly to the release of all
public information; that is, current security prices fully reflect all public information. The
semi-strong hypothesis encompasses the weak-form hypothesis, because all the market
information considered by the weak-form hypothesis, such as stock prices, rates of return,
and trading volume, is public. Notably, public information also includes all nonmarket
information, such as earnings and dividend announcements, price-to-earnings (P/E) ratios,
dividend-yield (D/P) ratios, price-book value (P/BV) ratios, stock splits, news about the
economy, and political news. This hypothesis implies that investors who base their
decisions on any important new information after it is public should not derive above-
average risk-adjusted profits from their transactions, considering the cost of trading
because the security price should immediately reflect all such new public information.
Strong-Form Efficient Market Hypothesis
 The strong-form EMH contends that stock prices fully reflect all information from
public and private sources. This means that no group of investors has monopolistic
access to information relevant to the formation of prices. Therefore, this hypothesis
contends that no group of investors should be able to consistently derive above-average
risk-adjusted rates of return. The strong-form EMH encompasses both the weak-form
and the semistrong-form EMH. Further, the strong-form EMH extends the assumption
of efficient markets, in which prices adjust rapidly to the release of new public
information, to assume perfect markets, in which all information is cost-free and
available to everyone at the same time.

Market Efficiency

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EFFICIENT

■ Weak Form Efficiency

■ Semi strong form Efficiency

■ Strong form Efficiency

those trading on analysis of historical trading information – should earn no abnormal

returns. Fundamental analysis of securities can provide an investor with information to

technical analysis will not work.

fundamental analysis would be reliable strategies to achieve superior returns, because

possess the information before the rest of the market does.

average investor even if he were privy to new insider information.

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