The Meaning of Market Efficiency
35 Pages Posted: 10 Mar 2011 Last revised: 1 Sep 2011
Date Written: August 31, 2011
Fama (1970) defined an efficient market as one in which prices always “fully reflect” available information. This paper formalizes this definition and provides various characterizations relating to equilibrium models, profitable trading strategies, and equivalent martingale measures. These various characterizations facilitate new insights and theorems relating to efficient markets. In particular, we overcome a well known limitation in tests for market efficiency, i.e., the need to assume a particular equilibrium asset pricing model, called the joint-hypothesis or bad-model problem. Indeed, we show that an efficient market is completely characterized by the absence of both arbitrage opportunities and dominated securities, an insight that provides tests for efficiency that are devoid of the bad-model problem. Other theorems useful for both the testing of market efficiency and the pricing of derivatives are also provided.
Keywords: efficient markets, information sets, strong-form efficiency, semi-strong form efficiency, weak-form efficiency, martingale measures, local martingale measures, no arbitrage, no dominance, economic equilibrium
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