Efficient Market Hypothesis

Abstract

A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, ¢, if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set, ¢, implies that it is impossible to make economic profits by trading on the basis of ¢. It has been customary since Roberts (1967) to distinguish three levels of market efficiency by considering three different types of information sets: (1) The weak form of the Efficient Market Hypothesis (EMH) asserts that prices fully reflect the information contained in the historical sequence of prices. Thus, investors cannot devise an investment strategy to yield abnormal profits on the basis of an analysis of past price patterns (a technique known as technical analysis). It is this form of efficiency that is associated with the term 'Random Walk Hypothesis'. (2) The semi-strong form of EMH asserts that current stock prices reflect not only historical price information but also all publicly available information relevant to a company's securities. If markets are efficient in this sense, then an analysis of balance sheets, income statements, announcements of dividend changes or stock splits or any other public information about a company (the technique of fundamental analysis) will not yield abnormal economic profits. (3) The strong form of EMH asserts that all information that is known to any market participant about a company is fully reflected in market prices. Hence, not even those with privileged information can make use of it to secure superior investment results. There is perfect revelation of all private information in market prices. WEAK FORM MARKET EFFICIENCY AND THE RANDOM WALK HYPOTHESIS. If markets are efficient, the (technical) analysis of past price patterns to predict the future 127 J. Eatwell et al. (eds.), Finance