5 Efficient Markets and What Prices Know
5.1 The Efficient Market Hypothesis
EMH describes the relationship between available information and prices. In the classic taxonomy, weak-form efficiency concerns past market data, semi-strong efficiency concerns public information, and strong-form efficiency concerns all information, including private information.
Efficiency does not mean prices are always correct in hindsight or that all investors share the same beliefs. It asks whether a specified information set reliably produces excess risk-adjusted returns after relevant costs.
5.2 Models meet evidence
Tests of efficiency generally require an asset-pricing model to define expected returns. A surprising return pattern may indicate a pricing inefficiency, an omitted risk factor, data selection, or a model error.
This is sometimes called the joint-hypothesis problem: we evaluate market efficiency and a model of normal returns at the same time.
5.3 A bridge to derivatives
Even if a market incorporates information quickly, a derivative still needs to be priced relative to possible future states and hedging opportunities. Option valuation focuses on the structure of the payoff and the cost of replicating or hedging it under specified conditions.
Discussion: How would trading costs change the economic value of a small statistical anomaly?
Living chapter. This is an initial working treatment. Derivations, examples, and references will be expanded in future editions.