Tests of capital market efficiencyis again explained by the portfolio effect. It may be that contestants choose to ask
the audience the easier, more obvious questions, but this difference in success rate is
still striking.Efficiency and speed of reaction
Efficiency requires not only that prices react rationally to new information, but also
that they react speedily. Certainly, the rate at which data can be transmitted, received,
and analysed, and the analysis transmitted, received, and acted upon by buying or
selling, is very rapid, particularly in this era of cheap electronic data communication
and processing.
Since there are large numbers of informed, highly motivated observers who are
capable of quick action, we have good reason to believe that a sophisticated secondary
capital market like the LSE would be efficient in its pricing of securities. The question
now becomes: is it efficient in practice?9.4 Tests of capital market efficiency
Forms of efficiency
Attempts to assess efficiency have addressed themselves not so much to whether the
capital markets are or are not efficient but rather to what extent they are efficient.
Roberts (1967) suggested that efficiency and tests of it should be dealt with under three
headings:
l Weak form. If the market is efficient to this level, any information that might be con-
tained in past price movements is already reflected in the securities’ prices.
l Semi-strong form. This form of efficiency implies that all relevant publicly avail-
able information is impounded in security prices.
l Strong form. If present this would mean that all relevant information, including
that which is available only to those in privileged positions (for example, man-
agers), is fully reflected in security prices.These are ascending levels of efficiency such that, if a market is strong-form efficient
it must, therefore, also be semi-strong and weak-form efficient.Approach taken by the tests
Propositions such as that relating to capital market efficiency are not directly testable.
How can we test whether all available information is reflected in security prices? The
researcher may not personally have all of the available information or even know that
some of it exists. We can, however, test whether or not security price behaviour seems
consistent with efficiency. Generally, the tests that have been carried out have tried to
do this.
The tests have sought to assess whether or not it seems possible to make abnormal
returns by exploiting any possible inefficiency. Abnormal returns in this context
means returns in excess of those that could be made, over the same period in which
the test was conducted, from securities of similar risk. Returns typically means capital‘
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