Types of market efficiency
There are three types of market efficiency. Together, they constitute the efficient market hypothesis (EMH), a hypothesis that was first formulated by Eugene Fama.
The market efficiency hypothesis states that
financial markets incorporate relevant information very quickly.
This means that it is very hard or impossible to earn positive risk-adjusted abnormal returns. The efficient market hypothesis distinguishes three forms of capital market efficiency. On this page, we discuss the efficient market hypothesis, the three forms of capital market efficiency, and the implications of each market efficiency type.
Efficient market hypothesis definition
What is the importance of the efficient market hypothesis? If the efficient market hypothesis is correct, it has very big implications for financial markets. In particular, financial market efficiency suggests that active stock selection is very difficult, if not impossible when markets are very efficient. As such, the EMH has clear implications for stock prices.
What are the necessary conditions or, better, what are the efficient market hypothesis assumptions? Generally, efficiency in a market is achieved when transaction costs are low, when there is full information transparency, there are no impediments to trading, and nobody is big enough to influence security prices permanently. These characteristics of an efficient market are not always met. Emerging markets, for example, tend to be less market efficient. Also, a capitalist market economy is more likely to be market efficient.
Now, let us turn to three types of market efficiency. Below, we describe the three different forms of market efficiency and then discuss the implications of each form.
Weak-form market efficiency
The weak-form EMH or weak efficient market hypothesis states that current security prices fully reflect all available security market data. This means that information contained in security prices and volume data are fully incorporated in current security prices.
Semi-strong form market efficiency
The semi-strong EMH states that all publicly available information is included in the security prices. This is broader than security price data and volume, since it also includes all other relevant information, such as company statements, news articles, etc.
Strong-form market efficiency
This is also sometimes referred to as the perfect market theory. The strong form efficiency theory states that private inside information also does not help you.
A good strong form efficiency example is a market for a security in which nobody can be expected to have insider information, for example a stock market index. This market is very likely to be strong-form market efficient, since nobody has insider information that will tell him or her the direction of the aggregate stock market.
implications of efficient market hypothesis
The implications of the efficient market hypothesis are the following. In the case of the weak-form efficiency EMH, it is not possible to active positive risk-adjusted returns using ‘technical analysis’. Past prices and volume have no predictive power about future direction of security prices. The semi-strong form EMH implies that fundamental analysis does not earn positive risk-adjusted returns on average. Finally, the strong form EMH implies that even insider information does not help you in earning abnormal returns. It is unlikely that the strong form efficiency holds in all markets.