Discuss the differences between weak form, semi-strong form and strong form capital market efficiency, and critically evaluate the significance of the efficient market hypothesis (EMH) for the financial manager, using examples or cases in real-life.

1. Question: Discuss the differences between weak form, semi-strong form and strong form capital
market efficiency, and critically evaluate the significance of the efficient market hypothesis (EMH) for
the financial manager, using examples or cases in real-life.
Introduction
The question of whether the stock market is efficient in pricing various securities and shares brought
continuous debates among investors, businessmen and academics in the past decades. In this area,
efficiency in the stock market can be defined as “the degree to which stock prices and other securities
prices reflect all available, relevant information” (Investopedia , 2017). As a consequence, investors look
for market inefficiencies which are sufficiently exploitable to gain a substantial profit. Financial
managers should be aware of the different implications associated with the stock market in order to make
more accurate investment decisions. Arnold (2013) writes that is very important that the stock markets
are efficient in order to (1) encourage share buying, (2) give correct signals to company managers, and
(3) help allocate resources. Therefore, for the purpose of this essay, the efficient market hypothesis will
be explored with a critical approach. First, I will provide an explanation of the concept and its
significance in the finance world. Secondly, the three different forms of efficiency will be outlined and
briefly analysed in order to gain a well-rounded understanding of the efficient market hypothesis,
followed by a critical evaluation of the effectiveness of the EMH in assessing investment decisions and
understanding the stock market environment.
The Efficient Market Hypothesis
The efficient market hypothesis (EMH) is a concept coined by the economist Eugene Fama (1970) and
Paul Samuelson (1965) and it is widely used in stock market analysis and share asset valuation. Defined
as “an investment theory that states it is impossible to "beat the market" because stock market efficiency
causes existing share prices to always incorporate and reflect all relevant information” (Investopedia,
2017), the EMH is one of the economic/financial theories with the most empirical evidence supporting
it, suggesting that it is a strong concept which enhances the understanding of the stock market
environment and behaviour (Jensen, 1978). Essentially, it implies that stocks are priced with rationality
and without bias with respect to the direction and size of the share price movement. As a consequence,

2. when news about a company come out (unforecastable source of information), the investor will try to
determine if the share is priced at a fair value, undervalued or overvalued for investment purposes given
all the current available information, that is “market efficiency”. Therefore, this type of efficiency is
defined as pricing efficiency and can be intended as the expectation of an investor “to earn merely a risk-
adjusted return from an investment as prices move instantaneously and in an unbiased manner to any
news” (Arnold, 2013). The following graph represents possible price reactions to news in an efficient
market system:
Source: (Arnold, 2013)
Yet, it may not be easy to determine if the available information and news is actually accessible to
everyone at the same time, thus creating a less efficient market. For this reason, EMH theorizes that the
market is generally efficient although under three different versions: weak form, semi-strong form and
strong form of capital market efficiency.
Weak-form: patterns in stock returns
Weak-form efficiency, also known as “random walk”, implies that future directions cannot be predicted
on the basis of past actions because present share prices fully reflect those past price movements. As

3. Malkiel (2007) writes, in the stock market this means that short-run changes cannot be predicted, where
chart patterns, advisory services and earnings predictions are useless. Advocates of this theory debate
that a randomly chosen portfolio would do just as well as one carefully selected by experts. Pursuant to
this theory, it is almost impossible to outperform the market because weak-form efficiency does not
consider technical and fundamental analysis to be accurate. In fact, “the weak form believes in the
efficient market hypothesis but also believes the market's analysis abilities are weak and may not be so
efficient at times” (Investopedia 2017). To support this claim, Marshall et al. (2010) conducted a study
on 5,000 technical trading rules in 49 countries and found no evidence that those rules are consistently
profitable over time.
Semi-strong: market anomalies
The semi-strong efficiency hypothesis suggests that the market is efficient with all publicly available
information but, however, there can be opportunities to take advantage of market anomalies. Thus, if
true, investors are unable to outperform the market if not by having insider knowledge or chance because
all public information, including technical and fundamental analyses, is already priced in. Stock markets
in the US and UK are considered semi-strong efficient because they quickly reflect all available
information in prices but at the same time provide room to take advantage of anomalies.
In fact, value investors seek to find stocks that are undervalued by the market due to an irrational sell off
(caused by economic distress, for example) and have good past performance/indicators, such as high
yield shares, high EPS ratios and high book-to-market ratios. First pioneered by Graham (1973), the
concept of value investing has proved to generate abnormal returns contrarily to what the semi-strong
EMH implies, as Basu (1983) and Keim (1988) found. Peter Lynch, Charlie Munger and Warren Buffett
are perfect examples of the fact that market anomalies are present and if exploited carefully can guarantee
superior returns in the long-run. To balance out, Arnold (2013) suggests that “the evidence for semi-
strong efficiency is significant but not so overwhelming that there is no hope of outperformance”
(Arnold, 2013).
Strong: insider information
The strong-form of efficiency indicates that all relevant information, including that which is privately

4. held, is reflected in the share price. Practitioners of this theory believe that an investor cannot make
abnormal returns even if classified information is available to him/her, because the overall market does
not follow a “random walk” and is indeed influenced by past events. However, this theory can be said to
be too extreme because it is practically impossible that common investors have the same knowledge of
insiders.
Volkswagen’s Emission Scandal
Here we shall look at VW’s stock behaviour following the news on the emission scandal in September
2015 under the three EMHs [VW lost a quarter of its market value (Kresge & Weiss, 2015)]:
• Weak: the market reacted efficiently as VW shares were priced down. However, past prices did
not determine the future moves caused by the news.
• Semi-strong: the market reacted efficiently as the news came out. Following the news, value
investors could have identified trading opportunities to gain substantial profits.
• Strong: the market was inefficient because some investors gained abnormal returns thanks to
insider knowledge, suggesting that the strong-form EMH is misleading.
As Bodie et al. (2014) note, all versions of EMH assert that prices should reflect all available information,
and that investors will always wish to have extra information to gain an advantage. Given the implications
of EMH, one cannot be sure if present and future market prices will be high or low but if markets are
rational one can expect them to be priced correctly (on average). Interestingly, Arnold (2013) writes that
“in order for the market to remain efficient there has to be a large body of investors who believe it to be
inefficient”, leading us to the next section which evaluates the EMH.
Discussion — are markets efficient?
It is clear that the EMH is very theoretical in its nature and it can be argued that it applies to real life up
to a certain extent. If an investor were to fully “obey” to the efficiency theories, he/she can make
relatively low returns with low risk because the markets have already priced the shares at the optimal
efficiency level with rationality and no bias. As a consequence, it can be said that markets are generally
efficient, as there is a mix of speculators, long/short term investors and technical/fundamental analysts

5. which eventually dictates the rational price of shares. Fama (1970) explained that the only rational way
of gaining a substantial return on an investment is purely through speculative investments that entail a
high level of risk. However, it can be debated that this is not always the case, as Warren Buffett and Peter
Lynch demonstrated with their billion dollar returns thanks to their different interpretation of
information. Additionally, it can be argued that Fama’s (1970) theories do not apply as accurately
nowadays given that the faith in EMH is slipping, as Tett (2009) writes. This is because the stock market
is a constant changing environment, where 84% of modern trading is done by high-frequency computers
that operate at an unthinkable speed (Demos, 2012). As a matter of fact, Malkiel (2007) states that
investors are understanding that the markets are becoming increasingly predictable and somehow
inefficient. For instance, Nichols (1993) explains that researchers have discovered that stocks perform
better in January and small-cap stocks tend to do better than large-cap ones: “two situations that should
not exist if the efficient market hypothesis portrayed the stock market accurately” (Nichols, 1993).
Conclusively, the concept of EMH is extremely important to the financial manger because it provides a
well-rounded basis to understand the stock market and possibly take advantage of “inefficiencies” for
corporate investment purposes.

6. Bibliography
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Keim , D. B., 1988. Stock market regularities: A synthesis of the evidence and explanations. Stock
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7. Malkiel, B. G., 2007. A Random Walk Down Wall Street. 9th edition ed. New York: W. W. Norton &
Company.
Marshall, B. R., Cahan, R. H. & Cahan, J., 2010. Technical Analysis Around the World. Massey
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