Efficient Market Theory (EMT)

Question 1

Efficient market

Answer 1

An efficient market is defined as one in which every security’s price equals its investment value at all times. The investment value is the present value of the security’s future prospects. Well-informed and skillful analysts use the information currently at hand to estimate this value. (Investment value is often referred to as the security’s “fair” or “intrinsic” value.)

In an efficient market a set of information is fully and immediately reflected in market prices. A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions. That is, in an efficient market, investors should expect to make only normal profits by earning a normal rate of return on their investments.

Question 2

Weak form efficient

Answer 2

It is impossible to make abnormal profits (other than by chance), by using past prices to formulate buying and selling decisions. In weak form, technical analysis is rendered worthless.

Question 3

Semi-strong form efficient

Answer 3

It is impossible to make abnormal profits (other than by chance), by using publicly available information to formulate buying and selling decisions. In semi-strong form, both technical analysis and fundamental analysis are rendered worthless.

Question 4

Strong form, or perfectly efficient

Answer 4

It is impossible to make abnormal profits (other than by chance), by using any information (public or private) to make buying and selling decisions. In strong form, all types of analysis are rendered worthless, including insider information.

Question 5

Perfectly efficient price

Answer 5

If the price of a security reflects everything that is knowable about the security, we call it a perfectly efficient price. A perfectly efficient price is always equal to the security’s value, even though the value may change continuously to reflect the random arrival of new information. In other words, the price and value react in unison to the frequent appearance of news. Smart financial analysts who are active traders will not be able to enrich themselves in a perfectly efficient market because all the securities are priced correctly.