What are the three forms of market efficiency and how is each tested?

Question

AcadiFi · Accepted Answer

The Efficient Market Hypothesis (EMH) by Eugene Fama states that security prices reflect available information. The three forms differ in **what kind of information** is assumed to be fully incorporated into prices.

```mermaid
graph TB
    subgraph "Information Sets"
    A["Strong Form
All Information
(Public + Private)"] --> B["Semi-Strong Form
All Public Information"]
    B --> C["Weak Form
Past Price & Volume Data"]
    end
    style A fill:#ef4444,color:#fff
    style B fill:#f59e0b,color:#000
    style C fill:#10b981,color:#fff
```

**Weak Form Efficiency:**
- Prices reflect all **past trading data** (historical prices, volume, returns)
- Implication: Technical analysis is useless because patterns are already priced in
- **Tests:** Serial correlation tests (do past returns predict future returns?), runs tests, filter rule tests
- If markets are weak-form efficient, you cannot earn abnormal returns using moving averages, chart patterns, or momentum strategies based purely on historical prices

**Semi-Strong Form Efficiency:**
- Prices reflect all **publicly available information** (financial statements, news, analyst reports, economic data)
- Implication: Neither technical nor fundamental analysis can generate consistent abnormal returns
- **Tests:** Event studies — examine whether stock prices fully adjust to announcements (earnings surprises, M&A, dividend changes) on the announcement date
- If the price adjusts immediately and completely, the market is semi-strong efficient
- If there is a post-announcement drift (prices continue trending after the news), it violates semi-strong efficiency

**Strong Form Efficiency:**
- Prices reflect **all information**, including private (insider) information
- Implication: Even corporate insiders cannot earn abnormal returns
- **Tests:** Studies of insider trading profitability, hedge fund manager performance
- Evidence: Generally rejected — insiders do earn abnormal returns, which is why insider trading is illegal

**Summary Table:**

| Form | Information Set | Technical Analysis | Fundamental Analysis | Insider Trading |
|---|---|---|---|---|
| Weak | Past prices | Cannot profit | May profit | May profit |
| Semi-Strong | All public | Cannot profit | Cannot profit | May profit |
| Strong | All (public + private) | Cannot profit | Cannot profit | Cannot profit |

**Example:** Suppose Ridgeline Pharmaceuticals announces FDA approval at 8:00 AM. Under semi-strong efficiency, the stock price should jump immediately at the open to reflect the new information. If you could still buy after the announcement and profit consistently, that would violate semi-strong efficiency.

**Exam alert:** The CFA exam frequently tests which anomalies (e.g., the January effect, small-firm effect, post-earnings drift) violate which form. Post-earnings drift violates semi-strong efficiency because public earnings data is not fully reflected on the announcement date.

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What are the three forms of market efficiency and how is each tested?

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Practice Questions

Form	Information Set	Technical Analysis	Fundamental Analysis	Insider Trading
Weak	Past prices	Cannot profit	May profit	May profit
Semi-Strong	All public	Cannot profit	Cannot profit	May profit
Strong	All (public + private)	Cannot profit	Cannot profit	Cannot profit