Financial Question in difference strong-from and weak form

Business & Finance
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What are the major differences between the strong-form and the weak-form of the efficient market hypothesis?

Nov 11th, 2014

Securities Markets - Weak, Semi-Strong and Strong EMH

The Three Basic Forms of the EMH
The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH) can be categorized into three basic levels:

1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid. 

2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information.

3. Strong-Form EMH 
The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information.

Weak Form Tests
The tests of the weak form of the EMH can be categorized as:

  1. Statistical Tests for Independence -In our discussion on the weak-form EMH, we stated that the weak-form EMH assumes that the rates of return on the market are independent. Given that assumption, the tests used to examine the weak form of the EMH test for the independence assumption. Examples of these tests are the autocorrelation tests (returns are not significantly correlated over time) and runs tests (stock price changes are independent over time).
  2. Trading Tests - Another point we discussed regarding the weak-form EMH is that past returns are not indicative of future results, therefore, the rules that traders follow are invalid. An example of a trading test would be the filter rule, which shows that after transaction costs, an investor cannot earn an abnormal return.

Semi-strong Form Tests
Given that the semi-strong form implies that the market is reflective of all publicly available information, the tests of the semi-strong form of the EMH are as follows:

  1. Event Tests - The semi-strong form assumes that the market is reflective of all publicly available information. An event test analyzes the security both before and after an event, such as earnings. The idea behind the event test is that an investor will not be able to reap an above average return by trading on an event.
  2. Regression/Time Series Tests - Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.

Strong-Form Tests
Given that the strong-form implies that the market is reflective of all information, both public and private, the tests for the strong-form center around groups of investors with excess information. These investors are as follows:

  1. Insiders - Insiders to a company, such as senior managers, have access to inside information. SEC regulations forbid insiders for using this information to achieve abnormal returns.
  2. Exchange Specialists - An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that exchange specialists can achieve above average returns with this specific order information.
  3. Analysts - The equity analyst has been an interesting test. It analyzes whether an analyst's opinion can help an investor achieve above average returns. Analysts do typically cause movements in the equities they focus on.
  4. Institutional money managers - Institutional money managers, working for mutual funds, pensions and other types of institutional accounts, have been found to have typically not perform above the overall market benchmark on a consistent basis.

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