Weak Form Market Efficiency

Weak-form of market efficiency postulates that past market date is fully reflected in the current market prices such that no rule derived from study of historical trends can be used to earn excess return.

Weak-form of market efficiency is the weakest form of efficient market hypothesis (EMH). Semi-strong form and strong form of market efficiency are the two other forms of efficient market hypothesis.

Weak-form of market efficiency implies that technical analysis cannot be used to predict future price movements. Technical analysis is the use of past price movements to predict future price fluctuations. However, in the weak form of market efficiency, fundamental analysis and non-public information can be used to earn excess return.

Tests for weak-form efficiency

Weak-form efficiency holds when there is no serial correlation in historical return on a security. Another test for weak-form efficiency is to look at trading rules arrived at using technical analysis. If no such rule can consistently generate excess return, markets are at least weak-form efficient. While some people argue that since psychology is one of the determinants of a security’s performance, information can be extracted from looking at past behavior of market participants, evidence of consistent excess return using technical analysis is lacking, at least in developed markets.

Example

Prashant recently started a job as a broker at the Punjab Stock Exchange. He has developed a recent interest in investments and has no prior experience. He observed that the price of Mohali Sports rises on Monday and drops on Friday. One Friday, he purchased 100 shares of MSE's stock for 11 INR per share hoping to sell them on Monday and earn a profit.

When the market opened on Monday, Mohali Sports declined to INR 10.5 per share.

The market seems to be weak-form efficient, because it is not letting Prashant earn excess return by just picking stocks based on some past price pattern.

by Obaidullah Jan, ACA, CFA and last modified on

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