The Efficient market hypothesis

The efficient market hypothesis (EMH) goes back to 1900, but its popularity is attributed to Roberts (1967) and Fama (1970).

The hypothesis defined the efficient market as a place where many rational individuals compete to maximise profit. In this market, all current and essential information is available free to all participants, while at the same time, there are no transaction costs.

The state of competition of intelligent participants leads to the situation where, at any point in time, the price of the stock reflects all past information, as well as any predictions of the future. Fama (1970) identified three levels of efficiency of the market: the strong form, the semi-strong form and finally, the weak form of the EMH.

Strong-form EMH

This form theorises that all the information relevant to the value of a share, regardless of the availability to potential investors, is always reflected promptly in the market price. This form is difficult to demonstrate, as the research lacks the cooperation of the insider dealers (members of the financial community and the executive board, with information not available to all investors).

Semi-strong-form EMH

This form restricts the efficient market as the case where all the relevant public information is quickly reflected in the market price. The problem of this hypothesis is the identification of what constitutes the relevant public information.

Weak-form EMH

It is the least rigorous form of the EMH. In this form, the relevant public information considered is only the historical data about the share itself. The author argues that new information should be unrelated to previous knowledge to be defined as new. Therefore, the share price movement due to new information cannot be predicted from old data, and the price is characterised as a “random walk”.