Forms of market efficiency:
- Weak form: In the weak form of market efficiency, security prices reflect all the historical data (pricing and volume) but not the public and private information. In such a market it is not possible to extrapolate the past patterns to predict future prices. Technical analysis is the practice of analyzing historical trading data to identify recurring patterns in security prices. In weak-form market efficiency, technical analysis should not yield returns higher than risk-adjusted returns (or abnormal returns). Empirical evidence suggests a weak form of market efficiency being present in developing economies like China and Brazil.
- Semi-strong form: In the semi-strong form of market efficiency, all the publicly available information like financial data, management changes, etc., as well as the historical information is already priced-in in the security prices. No single investor has access to information that can materially impact the returns from the security. Hence, analysis of public information will be useless in generating abnormal returns. Event study method is a way to check if the markets are semi-strong In this, the researcher first identifies the specific event like M&A or dividend announcement against which the hypothesis will be tested. She then selects a period of study and the stocks to be analyzed. The expected returns for each of the stocks are calculated on the event date (using methods like CAPM etc). The actual returns are then compared to the expected returns and if excess returns are close to zero, semi-strong efficiency is said to be present in the market.
- Strong form market efficiency is the one where all the available public and private information is fully reflected in the security price. In such a market company management should not be able to make abnormal returns by using information that has not been made public yet. However, the presence of strict insider trading laws prevents strong market efficiency to be present anywhere in the world. Researchers try to test whether excess returns can be made in a market by trading on private information.
Check your concepts:
(47.6) In a particular market, the security prices reflect all the available public information and historical data such as price and volume. The insider trading is prohibited in the market. The market is most likely to be a:
(a) Weak form efficient market
(b) Strong form efficient market
(c) Semi-strong form efficient market
Solution:
(47.6) Correct Answer is C: Since the prices reflect all the available public information and historical data, the market can either be semi-strong form efficient or strong form efficient. Since there is a prohibition of insider trading then it is more likely that the insider information is not reflected in the security prices. Thus, the market is most likely to be semi-strong form efficient.
