Eugene Fama developed a framework of market efficiency that laid out three forms of efficiency: weak, semi-strong, and strong. Each form is defined with respect to the available information that is reflected in prices. Investors trading on available information that is not priced into the market would earn abnormal returns, which are defined as excess risk-adjusted returns.
In the weak-form efficient market hypothesis, all historical prices of securities have already been reflected in the market prices of securities. In other words, technicians – those trading on analysis of historical trading information – should earn no abnormal returns. Research has shown that this is likely the case in developed markets, but less developed markets may still offer the opportunity to profit from technical analysis.
In a semi-strong-form efficient market, prices reflect all publicly known and available information, including all historical price information. Under this assumption, analyzing any public financial disclosures made by a company to determine a stock’s intrinsic value would be futile since every detail would be taken into account in the stock’s market price. Similarly, an investor could not earn consistent abnormal returns by acting on surprise announcements since the market would quickly react to the new information.
In a strong-form efficient market, security prices fully reflect both public and private information. Therefore, insiders could not generate abnormal returns by trading on private information because it would already figure into market prices. Researchers find that markets are generally not strong-form efficient as abnormal profits can be earned when nonpublic information is used.
In the following graph, we can clearly see that the weak form of market efficiency reflects only past market data, whereas the strong form reflects all past data, public market information, as well as insider information.
Market prices reflect:
|Forms of market efficiency||
If a skilled fundamental financial analyst and an insider trader all earn the same long-run risk-adjusted returns, what form of market efficiency is likely to apply?
A. Weak form
B. Semi-strong form
C. Strong form
The correct answer is C.
Since the insider trader can’t even earn higher risk-adjusted returns than the skilled fundamental financial analyst, the market must be strong-form efficient.
Reading 46 LOS 46d:
Contrast weak-form, semi-strong-form, and strong-form market efficiency