Efficient Market Hypothesis (EMH) Meaning

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information, and, therefore, the current prices of securities reflect all information about the security.

Fama divided the overall efficient market hypothesis (EMH) and the empirical tests of the hypothesis into three sub-hypotheses depending on the information set involved: (1) Weak-form EMH, (2) Semistrong-form EMH, and (3) Strong-form EMH.

 

# TYPES OF EMH

Weak-form of EMH

The weak-form EMH assumes that current stock prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information, such as odd-lot transactions and transactions by market makers. Because it assumes that current market prices already reflect all past returns and any other security market information, this hypothesis implies that past rates of return and other historical market data should have no relationship with future rates of return (that is, rates of return should be independent). Therefore, this hypothesis contends that you should gain little from using any trading rule which indicates that you should buy or sell a security based on past rates of return or any other past security market data.

 

Semistrong-form EMH

The semistrong-form EMH asserts that security prices adjust rapidly to the release of all public information; that is, current security prices fully reflect all public information. The semistrong hypothesis encompasses the weak-form hypothesis, because all the market information considered by the weak-form hypothesis, such as stock prices, rates of return, and trading volume, is public. Notably, public information also includes all nonmarket information, such as earnings and dividend announcements, price-to-earnings (P/E) ratios, dividend-yield (D/P) ratios, price-book value (P/BV) ratios, stock splits, news about the economy, and political news. This hypothesis implies that investors who base their decisions on any important new information after it is public should not derive above-average risk-adjusted profits from their transactions, considering the cost of trading because the security price should immediately reflect all such new public information.

 

Strong-form EMH

The strong-form EMH contends that stock prices fully reflect all information from public and private sources. This means that no group of investors has monopolistic access to information relevant to the formation of prices. Therefore, this hypothesis contends that no group of investors should be able to consistently derive above-average risk-adjusted rates of return. The strong-form EMH encompasses both the weak-form and the semistrong-form EMH. Further, the strong-form EMH extends the assumption of efficient markets, in which prices adjust rapidly to the release of new public information, to assume perfect markets, in which all information is cost-free and available to everyone at the same time.