Characteristics of Information Efficient Asset Markets

• expected returns move inline with the asset's systematic risk

• predictable movements in asset prices are only arising because:

  • either the market-wide risk premium for the asset's systematic risk changes
  • or the amount of the asset's systematic risk changes

• an asset's average return is a fair compensation for its risk contribution to a well diversified portfolio

• the price of an asset follows only a 'random walk' if

  • either he market-wide risk premium for systematic risk is not predictable
  • or the amount of an asset's systematic risk is unpredictable

• the return surprise of an asset, measured as the spread between realized return and its expec­tation, is ONLY driven by incoming information of previously unknown content, also called 'news'.

• the price of an asset jumps immediately upon the arrival of new information, and remains unchanged until new information comes in.

How to test whether an asset market is efficient?

• tests of market efficiency are tests on the asset's return innovations
• tests for market efficiency assume the applied model for expected returns is correct
• hence, tests on market efficiency are joint tests ( efficiency + model for expected returns)
• if the return residual is forecastable by old information, markets are not information efficient

Three different forms of market efficiency

Weak-Form: $\epsilon_t$ is not driven by $F_{t-k}, k >0$ information. So, chart analysis using past prices and any signal that relies on historic prices cannot identify mis-valued assets at time t.

Semi-Strong Form: $\epsilon_t$ is only driven by newly released public information at time t.