What do we mean by “eﬃcient markets”? Explain the idea behind testing for market eﬃciency

Expert Solution

Efficient markets states that the asset prices fully reflect all the available information. When the markets are efficient it is impossible to beat the market. No trader can earn above normal profits.

The 3 forms of market efficiency is :

weak form:
semi strong form
strong form

Weak form : The weak form of market efficiency states that, no fundamental or technical analysis can help traders earn profits in the market. As the the data on past prices and volume is completely reflected in the stock prices.

A test of weak form of market efficiency is to study the trading patterns. The stock price on day 1 should not reflect any correlation to the price on day t+ 1.

The semi strong form :

This form of market efficiency, states that all public information is completely reflected on the stock prices.A test of market efficiency is to check how fast the stock prices incorporate to the new news happening related to the stocks. For example,a any new acquisitions announces and its affect on the stock price.

Strong form of market efficiency; In this form of market efficiency, stocks reflect all the available public as well as private information.Tests of the strong form of market efficiency have analyzed whether professional money managers can consistently outperform the market.

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