The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms's activities under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.”
This paper reviews the theoretical and empirical literature on the efficient markets model. After a discussion of the theory, empirical work concerned with the adjustment of security prices to three relevant information subsets is considered. First, weak form tests, in which the information set is just historical prices, are discussed. Then semi-strong form tests, in which the concern is whether prices efficiently adjust to other information that is obviously publicly available (e.g., announcements of annual earnings, stock splits, etc.) are considered. Finally, strong form tests concerned with whether given investors or groups have monopolistic access to any information relevant for price formation are reviewed.1 We shall conclude that, with but a few exceptions, the efficient markets model stands up well.
Though we proceed from theory to empirical work, to keep the proper historical perspective we should note to a large extent the empirical work in this area preceded the development of the theory. The theory is presented first here in order to more easily judge which of the empirical results are most relevant from the viewpoint of the theory. The empirical work itself, however, will then be reviewed in more or less historical sequence.
Finally, the perceptive reader will surely recognize instances in this paper where relevant studies are not specifically discussed. In such cases my apologies should be taken for granted. The area is so bountiful that some such injustices are unavoidable. But the primary goal here will have been accomplished if a coherent picture of the main lines of the work on efficient markets is presented, along with an accurate picture of the current state of the arts.