Overview
The efficient market hypothesis is an expression of the idea that investors will purchase only the assets that they think will perform relatively well, and will sell any asset that they believe will not perform well. This process will increase the the price of assets with high expectations and decrease the price of the low expectation group until the prices reach an equilibrium where all assets have the same market expectation. (relative to risk)
Forms of the Hypothesis
- The Weak Form: The weak form asserts that there is no information in the price history of an asset that can aid in forecasting the future value.
- Semi Strong Form: The semi - strong form asserts that no public information can help in forecasting the future value of an asset. However, private information about the firm can give an advantage.
- Strong Form: The strong form asserts that there is no information which can aid an analyst in forecasting returns.
Tests of the Efficient Market Hypothesis
Tests of the Efficient Market Hypothesis are hard to forumulate, primarily due to the issue of risk. The expectation of returns can only be thought to be equivalent on a risk adjusted basis.
This means that in order to test the hypothesis, one either needs to specify how to do the risk adjustment, or one needs to compare assets that can be argued have equivalent risk. The measure is further complicated by the stochastic nature of the markets, meaning that one must utilize the tools of statistical hypothesis testing