Empirical test for different forms of market efficiency

05/02/2024 0 By indiafreenotes

Empirical Testing for the different forms of market efficiency—weak, semi-strong, and strong—has been a central endeavor in financial economics. These tests aim to ascertain how well financial markets reflect information in asset prices.

Empirical tests of market efficiency have played a critical role in our understanding of financial markets. While findings generally support weak and semi-strong form efficiencies, indicating that markets are adept at incorporating historical and public information into prices, the strong form efficiency has been more controversial. Insider trading studies and the mixed success of professional fund managers in consistently beating the market suggest that private information may not be fully reflected in stock prices. These empirical tests, while highlighting the efficiency of markets, also underscore their complexities and the influence of information asymmetry.

Weak Form Efficiency

Tests for weak form efficiency primarily focus on the predictability of stock prices based on past price and volume data. The rationale is that if markets are weak form efficient, past information should have no bearing on future price movements, rendering them unpredictable.

  • Serial Correlation Tests:

These tests look for correlations between successive price changes or returns. A finding of zero correlation would support the weak form efficiency, suggesting that past price changes cannot predict future price changes.

  • Runs Tests:

This test examines the independence of price movements by analyzing sequences of price increases and decreases. A sequence not significantly different from what would be expected by chance supports weak form efficiency.

  • Variance Ratio Tests:

These assess whether the variance of returns over longer periods is a multiple of the variance of one-period returns, consistent with the random walk hypothesis.


While many markets show a high degree of weak form efficiency, there are anomalies such as momentum and mean-reversion effects that challenge this form of efficiency.

Semi-Strong Form Efficiency

Semi-strong form efficiency tests investigate whether stock prices fully reflect all publicly available information immediately after it becomes available.

  • Event Studies:

The most common approach, event studies examine the speed and accuracy with which stock prices adjust to specific significant information events, such as earnings announcements, dividend announcements, mergers and acquisitions, and macroeconomic news. The abnormal returns around the event window are analyzed to determine if investors can earn above-normal returns.

  • Regression and Time-Series Analysis:

These are used to model the relationship between stock returns and public information variables, assessing if any predictable pattern exists that could be exploited.


Evidence generally supports semi-strong form efficiency, indicating that prices adjust quickly to new public information, though there are instances of post-announcement drift that suggest markets may not always be perfectly efficient.

Strong Form Efficiency

Strong form efficiency implies that no group of investors, including insiders with private information, can consistently achieve abnormal returns. Testing for strong form efficiency involves analyzing the returns earned by specific potentially informed groups.

  • Insider Trading Studies:

These examine the returns earned by corporate insiders on their trades. If insiders earn significant abnormal returns, it would suggest that markets are not strong-form efficient.

  • Private Information Tests:

Similar to insider trading studies, these tests look at the performance of professional fund managers or investors with presumed access to superior information to see if they can outperform the market consistently.


The evidence suggests that markets are not strong-form efficient. Insiders can and do earn abnormal returns on their trades, indicating that not all information is reflected in stock prices.