Efficient Market Hypothesis: Types of Efficiency Forms of Efficiency

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Efficient Market Hypothesis
 Definition
 Types of Efficiency
 Forms of Efficiency
 Weak Form
 Semi-Strong Form
 Strong Form
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Definition
 The efficient market hypothesis (EMH) is

the theory supporting the notion that
market prices are in fact fair
 Under the EMH, security prices fully and fairly
(i.e., without bias) reflect all available
information about the security
 Since the 1960’s, the EMH has been perhaps
the most important paradigm in finance
 Whether markets are efficient has been
extensively researched and remains
controversial
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Forms of Market Efficiency
 Eugene Fama’s original formulation of the

Efficient Market Hypothesis established three
forms of market efficiency, based on the
level of information reflected in security
prices:
1. Weak form = prices reflect all past market
level (price and volume) information
2. Semi-strong form = prices also reflect all
publicly available fundamental company
and economic information
3. Strong form = prices also reflect all privately
held information that would affect the value
of the company and its securities
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Definition
 The weak form of the EMH states that it is impossible

to predict future stock prices by analyzing prices
from the past
 The current price is a fair one that considers any

information contained in the past price data
 Charting techniques are of no use in predicting stock

prices
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Semi-Strong Form
 The semi-strong form of the EMH states that security

prices fully reflect all publicly available information
 e.g., past stock prices, economic reports, brokerage
firm recommendations, investment advisory letters, etc.
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Semi-Strong Form (cont’d)
 Academic research supports the semi-strong form of

the EMH by investigating various corporate
announcements, such as:
 Stock splits
 Cash dividends
 Stock dividends
 Examined through “event studies”
 This means investors are seldom going to beat the
market by analyzing public news
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 Market seems to do a relatively good job at

adjusting a stock’s valuation for certain types of
new information
• Determining how much the new info. will change the
stock’s value and then adjusting the price by an
equivalent amount
 This is what event studies examine
• But it does seem to have problems developing

an overall valuation for a stock in the first place
• E.g., What is the correct value for IBM as a whole is a
very difficult question to answer, but how much IBM’s
value should change if it is awarded a specific new
contract is much easier to determine
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 Burton Malkiel points out that two-thirds of

professionally managed portfolios are
consistently beaten by a low-cost index
fund
 Suggests that securities are accurately priced
and that in the long run returns will be
consistent with the level of systematic risk
taken
 Supports semi-strong form of the EMH
 Also would suggest that portfolio managers do
not possess any private information that is not
already reflected in security prices
 Supports the strong form of the EMH
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Strong Form
 The strong form of the EMH states that security prices

fully reflect all relevant public and private
information
 This would mean even corporate insiders cannot

make abnormal profits by using inside information
about their company
 Inside information is information not available to the

general public
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Are Markets Rational?
 This question always faces a joint hypothesis
problem:
 Tests of EMH are always dual tests of both market
efficiency and the specific asset-pricing model assumed
 Market efficiency
 Is the stock’s price equal to its true value?
 Asset pricing model used (CAPM, APT, etc.)
 What is the stock’s true value?
 Never known for sure
 “The question of value presupposes an answer to the question,
of value to whom, and for what?” – Ayn Rand
 E.g., the value of Apple stock would be different to Steve Jobs
than to any other investor
Are Markets Rational? 11
 Related issue – what is information?

 “Informationis that which causes changes” – Claude
Shannon (father of information theory)
 So,if something causes the markets to move, then by
definition, it must be information, and vice versa
 From this perspective, the market is neither efficient
nor inefficient, it just is
 So, are the markets efficient or rational?
 Ultimately, difficult to answer categorically
 Key question is not whether or not the markets are
efficient – this is a side issue – but how investors should
act, given how the markets work

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Efficient Market Hypothesis

 The efficient market hypothesis (EMH) is

 Eugene Fama’s original formulation of the

 The weak form of the EMH states that it is impossible

 The current price is a fair one that considers any

 Charting techniques are of no use in predicting stock

 The semi-strong form of the EMH states that security

 Academic research supports the semi-strong form of

 Market seems to do a relatively good job at

• But it does seem to have problems developing

 Burton Malkiel points out that two-thirds of

 The strong form of the EMH states that security prices

 This would mean even corporate insiders cannot

 Inside information is information not available to the

 Related issue – what is information?

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