Efficient Market Hypothesis

Most of the early work related to efficient capital markets was based on the random walk hypothesis, which contended that changes in stock prices occurred randomly. This early academic work contained extensive empirical analysis without much theory behind it.

Weak Form Efficient Market Hypothesis

Fama attempted to formalize the theory and organize the growing empirical evidence. Fama presented the efficient market theory in terms of a fair game model, contending that investors can be confident that a current market price fully reflects all available information about a security and the expected return based upon this price is consistent with its risk.

The weak-form EMH assumes that current stock prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information, such as odd-lot. transactions, block trades, and transactions by exchange specialists. Because it assumes that current market prices already reflect all past returns and any other security market information, the past rates of return and other historical market data should have no relationship with future rates of return. Therefore, this hypothesis contends that you should gain little from using any trading rule that decides whether to buy or sell a security based on past rate of return or any other past security market data.

Semistrong Form Efficient Market Hypothesis

The semistrong-form EMH asserts that. security prices adjust rapidly to the release of all public information: that is, current security prices fully reflect all public information. The sermistrong hypothesis encompasses the weak-form hypothesis, because all the market information considered by the weak-form hypothesis, such as stock prices, rates of return, and trading volume, is public. This hypothesis implies that investors who base their decisions on any important new information after it is public should not derive above-average risk-adjusted profits from their transactions, considering the cost of trading because the security price already reflects all such new public information.

Strong Form Efficient Hypothesis

The strong-form EMH cock prices fully reflect all information from public an.d private sources. This means that no group of investors has monopolistic access to information relevant to the formation of prices. Therefore, this hypothesis contends that no group of investors should be able to consistently derive above-average risk-adjusted rates of’ return. The strong-form EMH encompasses both the weak-form and the semistrong-form EMH. Further, the strong-form EMH extends the assumption of efficient markets, in which prices adjust rapidly to the release of new public information, to assume perfect markets, in which all information is cost-free to everyone at the same time.

Like most hypotheses in finance and economics, the evidence on the EMH is mixed. Some studies supported the hypotheses and indicate that capital markets are efficient. Results of other studies have revealed some anomalies related to these hypotheses, indicating results that do not support the hypotheses.