Market Efficiency

There are generally two theories to assist pricing. The Efficient Market Hypothesis (EFM) and the Behavioural Finance Theory. Understanding the limitations of each of the theories is critical. Read the three concepts on this page to have a comprehensive understanding of EFM. What are the limitations of the EMH?

Behavior of an Efficient Market

Efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient and should therefore move unpredictably.

Learning Objective

  • Describe what an efficient market looks like

Key Points

    • The efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". As a result, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
    • Historically, there was a very close link between EMH and the random-walk model and then the Martingale model. The random character of stock market prices was first modelled by Jules Regnault, a French broker, in 1863.
    • The definitions for three forms of financial market efficiency: weak, semi-strong, and strong.

Term

  • Martingale model

    In probability theory, a martingale is a model of a fair game where knowledge of past events will never help to predict future winnings.

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". As a result, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.

There are three major versions of the hypothesis: "weak," "semi-strong," and "strong". The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH also claims that prices instantly reflect even hidden or "insider" information. Critics have blamed the belief in rational markets for much of the late-2000's financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future. Market efficiency is a simplification of the world which may not always hold true. The market is practically efficient for investment purposes for most individuals.


Source: Boundless, http://kolibri.teacherinabox.org.au/modules/en-boundless/www.boundless.com/finance/textbooks/boundless-finance-textbook/security-market-efficiency-and-returns-9/market-efficiency-85/behavior-of-an-efficient-market-364-1030/index.html
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