Market Efficiency

The extent to which the financial markets digest relevant information into the prices is an important issue. If the prices fully reflect all relevant information instantaneously, then market prices could be reliably used for various economic decisions. For instance, a firm can assess the potential impact of increased dividends by measuring the price impact created by the dividend increase. Similarly, a firm can assess the value of a new investment taken up by ascertaining the impact on its market price on the announcement of the investment decision. Policymakers can also judge the impact of various macroeconomic policy changes by assessing the market value impact. The need to have an understanding about the ability of the market to imbibe information into the prices has led to countless attempts to study and characterize the levels of efficiency of different segments of the financial markets. The early evidence suggests a high degree of efficiency of the market in capturing the price relevant information. Formally, the level of efficiency of a market is characterized as belonging to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strong form efficiency. Weak-form Market Efficiency The weak-form efficiency or random walk would be displayed by a market when the consecutive price changes (returns) are uncorrelated. This implies that any past pattern of price changes are unlikely to repeat by itself in the market. Hence, technical analysis that uses past price or volume trends do not to help achieve superior returns in the market. The weak-form efficiency of a market can be examined by studying the serial correlations in a return time series. Absence of serial correlation indicates a weak-form efficient market. Semi-strong Market Efficiency The semi-strong form efficiency implies that all the publicly available information gets reflected in the prices instantaneously. Hence, in such markets the impact of positive (negative) information about the stock would lead to an instantaneous increase (decrease) in the prices. Semi-strong form efficiency would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. The hypothesis suggests that only information that is not publicly available can benefit investors seeking to earn abnormal returns on investments. All other information is accounted for in the stock price and regardless of the amount of fundamental and technical analysis one performs, above normal returns will not be had. The semi-strong form efficiency can be tested with event-studies. A typical event study would involve assessment of the abnormal returns around a significant information event such as buyback announcement, stock splits, bonus etc. Here, a time period close to the selected event including the event date would be used to examine the abnormal returns. Strong Market Efficiency The level of efficiency ideally desired for any market is strong form efficiency. Such efficiency would imply that both publicly available information and privately (non-public) available information are fully reflected in the prices instantaneously and no one can earn excess returns. A test of strong form efficiency would be to ascertain whether insiders of a firm are able to make superior returns compared to the market. Absence of superior return by the insiders would imply that the market is strongly efficient. Testing the strong-form efficiency directly is difficult. Therefore, the claim about strong form efficiency of any market at the best remains tenuous. In the years immediately following the proposal of the market efficiency, tests of various forms of efficiency had suggested that the markets are reasonably efficient. Over time, this led to the gradual acceptance of the efficiency of markets.