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Market efficiency assumes that a large number of profit maximizing
participants are analysing and valuing securities independent of each
Market efficiency assumes that new information comes to the market in a
random fashion and that the timing of news announcements are
independent of each other.
Investors adjust their estimate of security prices rapidly to reflect their
interpretation of the new information received. However, market efficiency
does not assume that market participants correctly adjust prices, just that
their price adjustments are unbiased. So, some will over adjust and some
will under adjust. (i.e. errors in market price are random)

The Theory:
An efficient capital market is one where the current price of a security fully
reflects all the information currently available about that security, including
An informationally efficient capital market is one in which security prices
adjust rapidly to new information.

There is no possibility that we can consistently make an abnormal
return based on the publicly available information.
In an efficient market, the expected returns from any investment will be
consistent with the risk of that investment over the long term, though there
may be deviations from these expected returns in the short term.

Market price is an unbiased estimate of the true value of the investment
This does not require the market price to be equal to true value at every
point in time
This requires that the errors in market price be random (unbiased)


The Weak-Form EMH assumes that current stock prices fully reflect all
currently available security market information (historical information).
Thus, info like past price and trading volume will have no relationship with the
future direction of security prices.

If the weak form of the EMH holds, then investors cannot achieve excess
returns using technical analysis.

The Semistrong-Form EMH asserts that security prices adjust rapidly to the
release of all new public information. Thus current security prices fully reflect all
market and non-market public information.

If the semistrong form of the EMH holds, then investors cannot achieve
excess returns using fundamental analysis.

The Strong-Form EMH asserts that stock prices fully reflect all information from
public and private sources. The strong form includes all types of information:
market, non-market public, and private (inside) information. This means
that no group of investors has monopolistic access to information relevant to the
formation of prices.

If the strong form of the EMH holds, then no group of investors should be
able to consistently achieve excess returns.

Norman Cheung



If security markets are completely efficient, portfolio managers will not be able
to earn above-market returns. In this case, the portfolio manager has several
First, the
diversification while minimizing transaction costs. Second, the portfolio
manager should help clients understand and quantify their risk tolerances and
return needs. Finally, the portfolio manager should monitor both the clients
needs and circumstances and changes in the capital markets.

In other words, portfolio managers must try to create/maintain a proper mix of

assets to meet their clients needs. Managers should always focus on the
minimization of transaction costs, taxes, and liquidity costs.


It is the actions of investors, sensing bargains and putting into effect schemes to
beat the market, that make the markets efficient

The necessary conditions for a market inefficiency to be eliminated are:

The market inefficiency should provide the basis for a scheme to beat the
market and earn excess return. For this to hold:
1. the assets(s), which is the source of inefficiency, has to be
2. transaction costs of executing the scheme have to be smaller
than the expected profits from the scheme
There should be profit maximising investors who
1. recognise the potential for excess return
2. can replicate the beat the market scheme that earns excess
3. have resources to trade on the stock until the inefficiency
Internal contradiction
no possibility to beat the market in EM
require investors to seek ways to beat the market and thus
make it efficient
if markets are efficient, investors will stop looking for
inefficiencies, leading to markets becoming inefficient again

Self-correcting mechanism
inefficiencies appear at regular intervals but disappear almost
instantaneously when found and traded on.


The efficient market hypothesis (EMH) states that:

security prices fully reflect all available information

o "available to the market /public" means that it must be accessible to
o This is a very strong hypothesis as it refers to all information. It is
therefore very hard easy to refute, as you only need to find one

security prices always equal fundamental value

o fundamental to the market but not to insiders
Formally: E(Pt | t-1) = E(Pt | t-1, t-1)

Norman Cheung

E(Pt | t-1) = information set used by the market
E(Pt | t-1) = specific information placed into the public


It implies:
- there is no possibility that we can consistently make an abnormal
return based on the publicly available information.
- if there is information put into the public domain that has not yet been
used by the market and has not yet been reflected into the price, then
there is an opportunity for investors to make an abnormal return
(provided the transaction costs are smaller then the abnormal returns).
More CFA info & materials can be retrieved from the followings:
For visitors from Hong Kong:
For visitors outside Hong Kong:

Norman Cheung