Rationale Behind the Hypothesis To see why the efficient

market hypothesis makes sense, we make use of the concept of

arbitrage, in which market participants (arbitrageurs) eliminate
unexploited profit opportunities, meaning returns on a security
that are larger than what is justified by the characteristics of
that security. Arbitrage is of two types: pure arbitrage, in which
the elimination of unexploited profit opportunities involves no
risk, and the type of arbitrage we discuss here, in which the
arbitrageur takes on some risk when eliminating the
unexploited profit opportunities. To see how arbitrage leads to
the efficient market hypothesis, suppose that, given its risk
characteristics, the normal return on a security, say, Exxon-
Mobil common stock, is 10% at an annual rate, and its current
price Pt is lower than the optimal forecast of tomorrow’s price
Pe t+1 so that the optimal forecast of the return at an annual
rate is 50%, which is greater than the equilibrium return of
10%. We are now able to predict that, on average, Exxon-
Mobil’s return would be abnormally high, so there is an
unexpected profit opportunity. Knowing that, on average, you
can earn such an abnormally high rate of return on Exxon-Mobil
because Rof 7 R*, you would buy more, which would in turn
drive up its current price relative to the expected future price
Pe t+1, thereby lowering Rof. When the current price had risen
sufficiently so that Rof equals R* and the efficient market
condition (Equation 4) is satisfied, the buying of Exxon-Mobil
will stop, and the unexploited profit opportunity will have
disappeared. Similarly, a security for which the optimal forecast
of the return is -5% while the equilibrium return is 10% (Rof 6
R*) would be a poor investment because, on average, it earns
less than the equilibrium return. In such a case, you would sell
the security and drive down its current price relative to the
expected future price until Rof rose to the level of R* and the
efficient market condition is again satisfied. What we have
shown can be summarized as follows: