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Forms of market efficiency

Eugene Fama defined three forms of efficiency depending on which information is reflected in market prices: weak, semi-strong and strong. A market is inefficient if abnormal returns (return in excess of expected return) are possible.

Weak-form

In a weak-form efficient market, security prices reflect all past information such that they cannot be used to consistently earn superior risk-adjusted returns.

Tests of weak-form

Weak-form efficiency holds when there is no serial correlation in historical return on a security. Another test for weak-form efficiency is to look at trading rules arrived at using technical analysis. If no such rule can consistently generate an excess return, markets are at least weak-form efficient.

While some people argue that since psychology is one of the determinants of a security’s performance, information can be extracted from looking at the past behavior of market participants, evidence of consistent excess return using technical analysis is lacking, at least in developed markets.

Semi-strong form

A market exhibit semi-strong efficiency if security prices incorporate all publicly available information quickly and accurately. A semi-strong form encompasses a weak-form which means if a market is semi-strong efficient, it is also weak-form efficient. Since all investors have access to public information, no one can earn excess return.

Tests of semi-strong form

The semi-strong form of efficiency is typically tested by studying how prices and volumes respond to specific events. If prices reflect new information quickly, markets are semi-strong form efficient. Such events may include special dividends, stock splits, lawsuits, mergers and acquisitions, tax changes, etc. Evidence suggests that developed markets might be semi-strong efficient while developing markets are not.

Strong-form

Strong-form efficiency in a market where security prices reflect all public and private information and even insiders are not able to earn abnormal returns. Since most countries have strong insider trading rules, insiders cannot trade on material non-public information and hence prices do not reflect such private information. Hence, it can be concluded that markets are not strong-form efficient.

Implications of the efficient market hypothesis

Fundamental analysis is the study of publicly available information such as earnings and sales forecasts, economic data, risk estimates, etc. to determine the intrinsic value of securities.

Usefulness of fundamental analysis

Fundamental analysis is useful both in a weak-form efficient and semi-strong form efficient markets. In the weak-form efficient market the present publicly available information is not currently reflected in the prices, hence, if an analyst has information about intrinsic values, he can buy undervalued securities and sell overvalued ones. In a semi-strong form efficient market, the utility of fundamental analysis is that it facilitates dissemination of publicly available information. It can also in the generation of abnormal returns of an investor’s fundamental analysis activities are cost-effective on a relative basis.

Usefulness of technical analysis

Technical analysis is the study of past price patterns in an attempt to forecast its future trajectory. Even in a weak-form efficient market, price patterns, if any, would not persist because market participants would know about them and trade accordingly such that they would disappear. In most cases, the trading costs are higher than the volume of price discrepancies and hence exploiting them is not profitable.

In a semi-strong form efficient market, the role of a portfolio manager is to create and manage portfolios keeping in view the risk and return objectives of his clients.

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