The Efficient Market Hypothesis

If you could predict next month’s share prices, you would be rich. The efficient market hypothesis says that, in a well-functioning market, you cannot, because the price already reflects what is known, and changes only when something new arrives, which by definition cannot be foreseen.

This idea is simple to state and has deep consequences: it says whether analysts can beat the market, whether a company can choose a good time to issue shares, whether creative accounting can fool investors, how quickly a share price reacts to the announcement of a project, and whether insiders can profit from early knowledge.

It also says something about how well a stock market does its job of directing money to where it is best used.

This topic explains the four kinds of market efficiency, the three forms of the hypothesis (weak, semi-strong and strong) with the evidence for each, the random walk and the chartists’ view, what each form implies for companies and investors, how to test efficiency by looking at abnormal returns around an event, and the factors that make real markets less than efficient, with worked examples. The next topic covers practical considerations in valuing shares.

The syllabus asks candidates to explain the efficient market hypothesis. Read valuing bonds and preference shares first.

Kinds of market efficiency

• Operational efficiency: transaction costs of buying and selling are low and do not discourage trading.
• Informational efficiency: information about companies is processed and made available to investors.
• Pricing efficiency: investors react quickly to new information, so that current prices are a fair reflection of it. This requires operational and informational efficiency, and it is what research on market efficiency tests.
• Allocational efficiency: funds are directed to their most productive uses; this follows from pricing efficiency, because if prices are fair, capital flows to the companies with the best prospects.

In an efficient market, all investors are reasonably well informed at about the same time, so some investors with “inside knowledge” cannot profit at the expense of others. Each can judge whether a price is too high or too low.

The three forms of the hypothesis

Weak form

In a weak-form efficient market, the current price reflects all historical information, including past prices and the past financial statements. Past price movements and trends therefore cannot be used to predict future ones; the next movement is as likely to be up as down. This is consistent with the random walk theory: prices move randomly as favourable or unfavourable news arrives.

It is opposed to chartism, the practice of chartists who draw graphs of share prices and look for patterns that they believe will repeat; on the weak form, chartism has no rational justification.

Semi-strong form

In a semi-strong form market the price reflects all publicly available information as well as the historical: an announcement about trading prospects, a new investment, a takeover bid. The price moves when the information becomes public, not before; unconfirmed rumours should not move it, while an official announcement should, at once.

But the holder of inside information (not yet public) can buy or sell ahead and make a profit. This is insider dealing, and it is illegal in countries with well-established markets, including Nigeria under the Investments and Securities Act.

Strong form

In a strong-form market the price reflects all information, including information not yet public, from the moment it exists. No one can profit from inside information, because the market already knows it. In practice, research suggests that most markets are at best weak-form or semi-strong form efficient; the most developed, such as New York and London, are semi-strong.

An illustration

A company decides on 3 March to start a project that will add ₦80m to its value and announces it on 20 April. The profits are published in the annual accounts the following year.

Under strong form the share price rises on 3 March, when the decision is made, by the full ₦80m. Under semi-strong form it rises on 20 April, when the news becomes public (between the two dates the news is inside information). Under weak form it does not respond to the announcement, but only when the results are published and the extra profits show up in the historical figures.

How efficiency is tested: abnormal returns

An event study measures the abnormal return around an event: the actual return less the return expected from the market movement. If a share has a beta of 1.2 and the market rises 1.0% on the day, the expected return is 1.2%. If the share rises 6.0% on the announcement day, the abnormal return is 6.0 − 1.2 = 4.8%.

Over the next four days the abnormal returns are +0.6%, −0.3%, +0.2% and −0.1%, so the cumulative abnormal return over the five days is 4.8 + 0.6 − 0.3 + 0.2 − 0.1 = 5.2%. In a semi-strong efficient market, the abnormal return occurs on the announcement day (or its first moments), and later days show only small, random figures (the net 0.4% after day one is close to nothing).

An abnormal return that builds up before the announcement suggests leakage of inside information; a return that drifts on for weeks after suggests that the market reacts slowly and is not fully efficient.

What efficiency implies

• Prices are fair: at any time the price reflects the information available, so there is no good or bad time to issue shares or bonds, and companies should not delay an issue to wait for a better price.
• Accounting manipulation does not pay: investors see through attempts to present results more favourably; changing an accounting policy with no cash effect should not change the price.
• No bargains: no systematic underpriced or overpriced shares, so investors who pay for analysis or trade frequently cannot expect to beat the market after costs; passive investing in a diversified portfolio is rational.
• Project NPV goes to the share price: a project with a positive net present value (NPV) raises the share price by its NPV per share, so the objective of maximising shareholders’ wealth is served by accepting all positive-NPV projects.
  A company with 300m shares priced at ₦12.00 (value ₦3,600m) that announces a project with an NPV of ₦90m should see its price rise by 90 ÷ 300 = ₦0.30, to ₦12.30 (2.5%).
• Information policy: in a semi-strong market, quick and honest disclosure matters, because the price reflects what the company says, and the market penalises surprises.

If the market is not efficient, managers may try to time issues, buy back shares when they think them undervalued (market timing, covered in the topic on financing choices), and be more careful in presenting results; investors may profit from analysis.

Real markets: why efficiency may fail

• Marketability and liquidity: the more a share is traded, the more quickly new information is reflected in its price. Thinly traded shares may go days without a trade, so the price is stale.
• Availability of information: not all information reaches all investors at the same time. Shares followed by professional analysts, who can afford better monitoring and earlier access, reflect information more fully; small companies with little coverage reflect less.
• Pricing anomalies: patterns such as the behaviour of prices around the end of the tax year, or at the start of the week, that appear to offer profits.
• Investor behaviour: herd behaviour, overreaction and underreaction, bubbles and crashes (the subject of behavioural finance) show that prices sometimes move away from fundamental value for long periods.
• Costs and limits to arbitrage: it may be costly or impossible to take advantage of a mispricing, so it persists.

Studies of emerging markets often find weaker efficiency than in the largest markets, because of thinner trading and slower or less complete disclosure; the Nigerian Exchange’s disclosure rules, the requirement for timely announcements by listed companies and the rules against insider dealing in the Investments and Securities Act aim to improve information efficiency.

A candidate should therefore discuss the form of efficiency that is likely for the market in the question, with evidence from the facts given.

The ideas in more depth

Why an efficient market has a random walk

If today’s price reflects everything known, tomorrow’s price will change only because of tomorrow’s news, which is by nature unpredictable. The price changes therefore look random even though the market is behaving rationally. Randomness is the sign of an efficient market, not of a foolish one: if price changes were predictable, investors would exploit the pattern and in doing so would remove it.

Why the hypothesis is tested jointly

To say that an abnormal return exists one needs a model of the normal return (for example the capital asset pricing model). If an apparent anomaly appears, either the market is inefficient or the model of the expected return is wrong. Tests of efficiency are therefore always tests of the market and the model together, which is why the debate has never been fully settled.

Sources and references

• Insider dealing and market abuse are dealt with in the Investments and Securities Act 2025 and the Securities and Exchange Commission rules. Listed companies’ disclosure obligations are in the Nigerian Exchange rulebook. The hypothesis is from the work of Fama (1970).

These points are stated as at 5 November 2026.

Worked examples

1. Expected.
   1.2 × 1.0 = 1.2%.
2. Abnormal.
   6.0 − 1.2 = 4.8%.

1. Per share.
   90 ÷ 300 = ₦0.30.
2. Price.
   12.00 + 0.30 = ₦12.30.

1. Rule. Prices react to public information.
2. Date. 20 April.

How to answer in the exam

• Define the form in question and say what information the price reflects.
• Apply it to the timeline in the case: when does the price move?
• State the implications for the company’s decisions and investors’ strategies.
• Discuss real-market limits: liquidity, information and anomalies.

Common mistakes in the exam

• Saying that an efficient market means prices never fall.
• Confusing weak form (past prices) with semi-strong form (public information).
• Saying that insiders can profit in a strong-form market.
• Describing chartism as consistent with the weak form.
• Forgetting that efficiency is about information, not about prices being correct in hindsight.
• Giving definitions without applying them to the case.

Quick revision

• Weak: past prices; semi-strong: all public information; strong: all information.
• Random walk; chartism; insider dealing.
• Efficient market: fair prices, no good time to issue, NPV goes to the price.
• Limits: liquidity, information, anomalies, behaviour.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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