Market efficiency concerns the extent to which market prices incorporate available information. Investors are interested in market efficiency because if prices do not fully incorporate information, then opportunities exist to make abnormal profits. Governments and regulators are interested in market efficiency because market efficiency promotes economic growth.
The following factors affect a market’s efficiency:
Two types of costs are incurred by traders when trading on market inefficiencies: transaction costs and information-acquisition costs. These costs should be considered when evaluating a market’s efficiency.
The table below introduces three forms of market efficiency which are differentiated based on assumptions about the level of information in security prices.
|Market Prices Reflect:
|Forms of Market Efficiency
|Past Market Data
Evidence that investors can consistently earn abnormal returns by trading on the basis of information would challenge the efficient market hypothesis.
In a weak-form efficient market:
Tests to check whether securities markets are weak-form efficient:
In a semi-strong-form efficient market:
Tests to check whether securities markets are semi-strong-form efficient:
In a strong-form efficient market:
Tests to check whether securities markets are strong-form efficient:
We can draw the following implications of efficient markets on developed markets:
|Form of Market Efficiency
|Securities markets are weak-form efficient.
|Investors cannot earn abnormal returns by trading on the basis of past trends in price.
|Technical analysts assist markets in maintaining weak-from efficiency.
|Securities markets are semi-strong-from efficient.
|Analyst must consider whether the information is already reflected in security prices and how any new information affects a security’s value.
|Fundamental analysts assist markets in maintaining semi-strong-form efficiency.
|Securities markets are NOT strong-from efficient.
|Investors trading on private information can make abnormal profits.
|Regulations try to prevent insider trading.
The role of portfolio managers is not necessarily to beat the market, but to establish and manage portfolios consistent with their clients’ objectives and constraints.