RDP 2000-01: The Efficient Market Hypothesis: A Survey 1. Introduction

The efficient market hypothesis is concerned with the behaviour of prices in asset markets. The term ‘efficient market’ was initially applied to the stockmarket, but the concept was soon generalised to other asset markets.

In this paper, we provide a selective review of the efficient market hypothesis. Our aim is to discuss the main ideas behind the hypothesis, and to provide a guide as to which of its predictions seem to be borne out by empirical evidence, and which do not. In examining the empirical evidence, we concentrate on the stock and foreign exchange markets, though much of the discussion is relevant to other asset markets, such as the bond and derivatives markets.

The vast majority of the empirical work on the efficient market hypothesis in the stock and foreign exchange markets has been done using data on the US stockmarket and on exchange rates against the US dollar. Our review also has this focus. US markets are probably the deepest and most competitive financial markets in the world, so they provide a favourable testing ground for the efficient market hypothesis.

The next section of the paper provides a concise definition of the hypothesis, and discusses some of the subtleties involved in defining an efficient market. The following section, which forms the bulk of the paper, turns to the predictions of the efficient market hypothesis, and discusses how they hold up when confronted with the empirical evidence on asset market behaviour. The paper ends with a brief discussion and conclusion.