6.1 Types of Efficiency

 Efficient market hypothesis can be explained in 3 ways:

  1. Allocative Efficiency

A market is allocatively efficient if it directs savings towards the most efficient productive enterprise or project. In this situation, the most efficient enterprises will find it easier to raise funds and economic prosperity for the whole economy should result.

Allocative efficiency will be at its optimal level if there is no alternative allocation of funds channelled from savings that would result in higher economic prosperity. To be allocatively efficient, the market should have fewer financial intermediaries such that funds are allocated directly from savers to users, therefore financial disintermediation should be encouraged.

  1. Operational Efficiency

This concept relates to the cost, to the borrower and lender, of doing business in a particular market. The greater the transaction cost, the greater the cost of using financial market and therefore the lower the operational efficiency. Transaction cost is kept as low as possible where there is open competition between broker and other market participants. For a market to be operationally efficient, therefore, we need to have enough market markers who are able to play continuously.

  1. Information Efficiency

This reflects the extent to which the information regarding the future prospect of a security is reflected in its current price. If all known (public information) is reflected in the security price, then investing in securities becomes a fair game. All investors have the same chances mainly because all the information that can be known is already reflected in share prices. Information efficiency is important in financial management because it means that the effect of management decision will quickly and accurately be reflected in security prices. Efficient market hypothesis relates to information processing efficiency. It argues that stock markets are efficient such that information is reflected in share prices accurately and rapidly.

6.2 Forms of Efficiency

Informational efficiency is usually broken down into 3 different levels (forms):

a. Weak form level of efficiency

This level states that share prices fully reflect information in historic share price movement and patterns (past information/historic information). If this hypothesis is correct, then, it should be possible to predict future share price movement from historical patterns. E.g. If the company’s shares have increased steadily over the past few months to the current price of Shs.30, then this price will already fully reflect the information about the company’s growth and therefore the next change in share prices could either be upward, downward or constant with equal probability. It therefore follows that technical analysis or Chartism will not enable investors to make arbitrage profits. In markets that have achieved this level then security prices follow a trendles random walk.

 Studies to test this level have been based on the principle that:

    • The share price changes are random

    • That there is no connection between share price movement and new share price changes. It is possible to prove statistically that there is no correlation between successive changes in price of shares and therefore trend in share price changes cannot be detected. This can be done by using serial correlation (or auto-correlation) test such as Durbin Watson Statistics.

b) Semi-Strong form level of Efficiency

This level states that share prices reflects all available public information. (past and present information). If the market has achieved this level, then fundamental analysis will not enable investors to earn consistently higher than average returns. Fundamental analysis involves the study of company’s accounts to determine its theoretical value and thereby find any undervalued share. Fundamental theory states that every share in the market has an intrinsic value, which is equal to the present value of cash flows expected from the security.

Tests to prove semi-strong form of efficiency have concentrated on the ability of the market to anticipate share price changes before new information is formally announced. These tests are referred to as Event Studies. E.g. if two companies plans to merge, share prices of the 2 companies will change once the merger plans are made public. The market would show semi-strong form of efficiency if it were able to anticipate such changes so that share prices of the company would change in advance of the merger plans being confirmed. Other events that can affect share prices are:

  1. Stock splits

  2. Death of CEO of company

  3. Investment in major profitable projects

  4. Changes in dividend policy, etc

c) Strong form level of Efficiency

This level states that price reflects all the available public and private information (past, present and future information). If the hypothesis is correct, then, the mere publication of information that was previously confidential should not have impact on share prices. This implies that insider trading is impossible. It follows therefore, that in order to maximize shareholders’ wealth, managers should concentrate on maximizing the NPV of each investment.

 Tests that have been carried out on this level have concentrated on activities of fund managers and individual investors. If the markets have reached the strong form levels, then fund managers cannot consistently perform better than individual investors in the market.


  1. The Timing Of Financial Policy

Some financial managers argue that there is a right or wrong time to issue securities i.e. new shares should only be issued when the market is at the top rather than the bottom. If the market is efficient, however, price follows a trendless random walk and its impossible for managers to know whether today’s price is the highest or the lowest. Timing other policies e.g release of financial statements, announcement of stock splits, etc has no effect on share prices.

  1. Project Evaluation Based Upon NPV

When evaluating new projects, financial managers use the required rate of return drawn from securities traded in the capital market. For example, the rate of return required on a particular project may be determined by observing the rate of return required by shareholders of firms investing in projects of similar risk. This assumes that securities are fairly priced for the risks that they carry (i.e. the market is efficient).

If the market is inefficient, however, financial managers could be appraising projects on a wrong basis and therefore making bad investment decisions since their estimate on NPV is unreliable.

  1. Creative Accounting

In an efficient market, prices are based upon expected future cash flow and therefore they reflect all current information. There is no point therefore in firms attempting to distort current information to their advantage since investors will quickly see through such attempts. Studies have been done for example to show that changes from straight-line depreciation to reducing balance method, although it may result to increasing profit, may have no long-term effect on share prices. This is because the company’s cash flows remain the same. Other studies support the conclusion that investors cannot be fooled by manipulation of accounting profit figure or charges in capital structure of company. Eventually, the investors will know the cash flow consequences and alter the share prices consequently.

  1. Mergers and Takeovers

If shares are correctly priced then the purchase of a share is a zero NPV transaction. If this is true then, the rationale behind mergers and takeovers may be questioned. If companies are acquired at their correct equity position then purchasers are breaking even. If they have to make significant gains on the acquisition, then they have to rely on synergy in economies of scale to provide the saving. If the acquirer (or the predator) pays the current equity value plus a premium, then this may be a negative NPV decision unless the market is not fully efficient and therefore prices are not fair.

  1. Validity of the current market price

If markets are efficient then they reflect all known information in existing share prices and investors therefore know that if they purchase a security at the current market price they are receiving a fair return and risk combination. This means that under or over valued shares or market securities do not exist. Companies shouldn’t offer substantial discounts on security issues because investors would not need extra incentives to purchase the securities.