Every practitioner model in this unit — the CAPM, the APT, the factor risk models used in performance evaluation — implicitly assumes that prices move toward fair value and that mispricings are short-lived. The Efficient Market Hypothesis (EMH) makes this implicit assumption explicit: security prices at any point in time fully reflect all available information relevant to their value. If the EMH holds, no analysis of public information can systematically generate risk-adjusted excess returns — trading costs would erode any edge. If it fails, the nature of the failure tells us which types of analysis are valuable.
The practical stakes are high. The EMH determines:
- Whether active management can add value beyond a passive index strategy.
- How fast you need to act on new information before the market fully prices it.
- Which factor risk premia are genuine systematic risk compensation vs exploitable mispricing.
This note develops the EMH from its theoretical foundation (the fair game condition) through its three empirical forms and the key tests of each. It also covers the two modern modifications that qualify the EMH without abandoning it: the Grossman-Stiglitz paradox (markets need informed traders to be efficient, but informed trading is costly) and the limits-of-arbitrage framework (Shleifer-Vishny), which explains why known mispricings can persist even when widely recognised.
Learning objectives. By the end of this note you should be able to:
- state the EMH and explain what "fully reflect" means in practice;
- distinguish the three forms of the EMH and identify the information set each tests;
- explain the fair game model and the random walk model, and state the relationship between them;
- describe the Grossman-Stiglitz paradox and its resolution;
- explain limits of arbitrage and why rational arbitrageurs may fail to eliminate known mispricing;
- state the joint hypothesis problem and why it prevents a definitive test of market efficiency.
In this lesson
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- What efficiency means
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- The three forms
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- The fair game condition
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- The Grossman-Stiglitz paradox
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- Limits of arbitrage (Shleifer-Vishny 1997)
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- The joint hypothesis problem
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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