WHAT IS AN EFFICIENT MARKET?

The efficient market is about

How well do markets respond to new information?
Should it be possible to decide between a profitable and unprofitable investment given current information
As we know Investors determine stock prices on the basis of the expected cash flows to be received from a
stock and the risk involved. So, the investors use all the information they have available or can reasonably to
obtain. Because Information is the key to the determination of stock prices and information is the central
issue of the efficient markets concept.
WHAT IS AN EFFICIENT MARKET?
The prices of all securities quickly and fully reflect all available information
If markets are efficient, then all information is already incorporated into prices, and so there is no way to
"beat" the market because there are no undervalued or overvalued securities available.
At its core, market efficiency is the ability of markets to incorporate information that provides the maximum
amount of opportunities to purchasers and sellers of securities to effect transactions without increasing
transaction costs.

Condition of efficient market

These conditions consider how closely they parallel the actual investments environment.
1. Large number of rational and profit-maximizing investors
A large number of investors are constantly “playing the game.” Actively participate in the market
Individuals cannot affect market prices
2. information is costless, widely available, generated in a random fashion
for institutions in the investments business generating various types of information it a necessary cost of
business, and many participants receive it “free” (investors may pay indirectly for such items in their
brokerage costs and other fees).
Information is largely generated in a random fashion, in the sense that most investors cannot predict when
companies will announce significant new developments, when oil disruptions will occur, when major weather
events will affect economies, when currencies will be devalued, when important leaders will suddenly suffer
a heart attack, and so forth.
3. Investors react quickly and fully to new information
The efficient market concept does not say that all investors are rational and react quickly to new information,
only that markets in the aggregate are rational. Many investors with substantial resources, and arbitrageurs,
are generally rational and ready to act on information.
Three levels of Market Efficiency
Weak form Prices reflect all market data past price and volume data
Semi-strong form Prices reflect all publicly available information
Strong form Prices reflect all information, public and private

There are three degrees of market efficiency.

The weak form of market efficiency is that past price movements are not useful for predicting future prices. If
all available, relevant information is incorporated into current prices, then any information relevant
information that can be gleaned from past prices is already incorporated into current prices. Therefore future
price changes can only be the result of new information becoming available. Given this argument,
momentum rules or technical analysis techniques that some traders use to buy or sell a stock will not on
average be able to achieve above normal market returns. Excess returns might still be possible using
fundamental analysis under weak-form market efficiency.

The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public
information so that an investor cannot benefit over and above the market by trading on that new information.
This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve
superior returns, because any information gained through fundamental analysis will already be available and
thus already incorporated into current prices. Only private information unavailable to the market at large will
be useful to gain an advantage in trading, and only to those who possess the information before the rest of the
market does.

The strong form of market efficiency says that market prices reflect all information both public and private,
building on and incorporating the weak form and the semi-strong form. Given the assumption that stock
prices reflect all information (public as well as private), no investor, including a corporate insider, would be
able to profit above the average investor even if he were privy to new insider information.

Investors have a wide range of viewpoints on the actual efficiency of the market, as reflected in the strong,
semi-strong, and weak versions of the EMH. Believers in strong form efficiency agree with Fama and often
consist of passive index investors. Practitioners of the weak version of the EMH believe active trading can
generate abnormal profits through arbitrage, while semi-strong believers fall somewhere in the middle.
For example, at the other end of the spectrum from Fama and his followers are the value investors, who
believe stocks can become undervalued, or priced below what they are worth. Successful value investors
make their money by purchasing stocks when they are undervalued and selling them when their price rises to
meet or exceed their intrinsic worth.

People who do not believe in an efficient market point to the fact that active traders exist. If there are no
opportunities to earn profits that beat the market, then there should be no incentive to become an active trader.
Further, the fees charged by active managers are seen as proof the EMH is not correct because it stipulates
that an efficient market has low transaction costs.

Evidence on Market Efficiency

The key to testing the validity of any of the three forms of market efficiency is the consistency with which
investors can earn returns in excess of those commensurate with the risk involved, conditional upon the
information set involved.
Therefore, it makes sense to talk about an economically efficient market, where assets are priced in such a
manner that investors cannot exploit any discrepancies and earn excess risk-adjusted returns after
consideration of all transaction costs.
An Example of an Efficient Market
While there are investors who believe in both sides of the EMH, there is real-world proof that wider
dissemination of financial information affects securities prices and makes a market more efficient.

For example, the passing of the Sarbanes-Oxley Act of 2002, which required greater financial transparency
for publicly traded companies, saw a decline in equity market volatility after a company released a quarterly
report. It was found that financial statements were deemed to be more credible, thus making the information
more reliable and generating more confidence in the stated price of a security. There are fewer surprises, so
the reactions to earnings reports are smaller. This change in volatility pattern shows that the passing of the
Sarbanes-Oxley Act and its information requirements made the market more efficient. This can be considered
a confirmation of the EMH in that increasing the quality and reliability of financial statements is a way of
lowering transaction costs.

Other examples of efficiency arise when perceived market anomalies become widely known and then
subsequently disappear. For instance, it was once the case that when a stock was added to an index such as
the S&P 500 for the first time, there would be a large boost to that share's price simply because it became part
of the index and not because of any new change in the company's fundamentals. This index effect anomaly
became widely reported and known, and has since largely disappeared as a result. This means that as
information increases, markets become more efficient and anomalies are reduced.