Understanding Market Efficiency: Key Concepts and Forms Explained

Market Efficiency

One of the most important financial theories is the efficient market hypothesis. The efficient market refers to the informationally efficient market. This implies that the prices of securities fully reflect all available information.

Therefore, in an inefficient capital market, the prices of stocks are adjusted almost immediately to reflect the new information. If the market is informational, it is impossible to make any abnormal or excess returns from this market.

An efficient market holds the following assumptions of the perfect capital market:

  • The information must be costless, and it must be available to all market participants at the same time.
  • There can be no transaction costs, taxes, or other barriers to trading.
  • Prices cannot be affected by the trading of a single person or institution

Based on the informational .contents and efficiency, a market can be divided into three forms:

Weak form efficient market

Weak form efficiency implies that all information contained in past price movements is fully reflected in current market prices.

Weak form efficient market assumes that current stock prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume, and other market-segmented information such as odd-lot transactions.

Semi-strong form efficient market

In the semi-strong form efficient market, the current market prices reflect the information that is contained in past price movements and all other publicly available information.

That means if the market is semi-strong form efficient, then all the security market information, which includes historical, the sequence of prices, rates of return, trading volume, odd-lot transactions, and all public information, which includes nonmarket information such as earnings and dividend announcement, price to earnings ratios, dividend payout ratio, stock split, news about economy, and political news are reflected in current market prices.

In a semi-strong efficient market, there is no need to be concerned about the formations that are published in the annual report, financial magazines, and financial news services because any information inherent in these documents or publications will already be incorporated into stock prices.

Strong form efficient market

The strong form of efficient market hypothesis implies that current market prices reflect all information that is available from public and private sources. That means strong form EMH encompasses both the weak-form and semi-strong form efficient market hypothesis.

No one, even the insiders -defined as directors, officers, and major shareholders- would find it impossible to earn excess returns. In reality, there is no existence of a strong form of an efficient market.