NISM Series XIX-C · Chapter 3: Concept of Informational Efficiency

L1 · Foundation

Foundation — What an efficient market actually claims

Operational versus informational efficiency, the precise technical definition of an efficient market, why price need not equal value, and the difference between market price and intrinsic value.

15 min read · Worth 0% of the paper · Written from pages 47–52 of the official NISM workbook · Updated 18 September 2026

3.1 Two kinds of efficiency

Operational efficiency with respect to capital market typically measures the cost of transacting i.e. cost of carrying out trades in the market. Thus, it is concerned with transactions costs or impact cost. Market is said to become operationally efficient if the cost of transacting in the market is going down.

There has been voluminous research on market efficiency since it has implications on portfolio management as well as on security analysis. Popularly the term market efficiency is used in the context of informational efficiency rather than operational efficiency.

Operational efficiency = the cost of transacting. Informational efficiency = whether prices reflect information. When anyone says "market efficiency" without qualification, they mean the second.

The popular definition

In common parlance, an informationally efficient market is one in which prices always "fully reflect" the most up to date current information. Hence a popular definition of efficient market is one where market price equals fair value of the securities.

The technical definition — and why it is different

This is the most important paragraph in the chapter, and candidates routinely misread it:

In technical terms, an efficient market is one where the market price is an unbiased estimate of the true value of the security. It implies that in an efficient market, price of a security need not be equal to its true value, as long as deviations of the price from the value is random in nature.

This means that price can be greater than or less than the true value. Randomness means that there is an equal chance that security is under or over or fairly valued at any point in time.

Further it implies that these deviations are uncorrelated with any observable market variable. This means that no investor should be able to consistently find under-valued or over-valued securities using any investment strategy with the objective of generating abnormal return.

Read the difference carefully. The popular definition says price equals value. The technical definition says price is an unbiased estimate of value — which permits price to be wrong, provided it is wrong randomly and uncorrelated with any observable market variable.

That distinction does real work. An efficient market is not one where nothing is ever mispriced. It is one where mispricing cannot be systematically found. The word to hold on to is unbiased: errors exist, but they do not lean in a predictable direction.

3.1.1 Market price versus intrinsic value

Market price is the price at which a security is currently available for trading. Investors can buy or sell the security at this price.

The market price mimics security's fair intrinsic value (sometimes called fundamental value). Broadly speaking, it is the value that would be placed on the asset by investors if they had a complete understanding of the asset's investment characteristics.

What "complete understanding" would require

For a company's stock, for example, such information would include its financial information like profit margins, sales, financial structure, information about the promoters and the management, SWOT analysis of the company, information on the sector to which the company belong and the placement of the company in the sector, its competitive advantages, the nature of the business, information of the macro-economic variables and how they would impact the sector and in turn the company's stock etc.

All such information would help in estimating the company's future cashflows and thereby the value of its stock.

And the honest admission:

The word estimate is used because, in practice, intrinsic value can only be estimated and is not known for certain.

That is worth pausing on. Intrinsic value can only be estimated and is not known for certain. Nobody has the true number to compare a price against — which is why testing market efficiency is so difficult and why the evidence, as section 3.3 admits, is mixed.

What your belief about efficiency does to your behaviour

When market is believed to be efficient by the investor, the market price is taken as a good measure of value.

When investors do not believe that the markets are efficient, they try to estimate the intrinsic value of the securities. When they estimate the intrinsic value of the security that is different than its market price, the security becomes a candidate for buy or sell with a view to gain returns i.e. alpha.

Whereas when the market is believed to be efficient, trades would take place only for the purpose of liquidity and portfolio rebalancing.

Belief	What the investor does
Market is efficient	the market price is taken as a good measure of value; trades happen only for the purpose of liquidity and portfolio rebalancing
Market is not efficient	try to estimate the intrinsic value; where estimate differs from price, the security becomes a candidate for buy or sell with a view to gain returns i.e. alpha

Notice what disappears if you believe in efficiency: security analysis as a source of return. You would still trade — to raise cash, to rebalance — but never because you thought a share was cheap.

3.2 The Random Walk hypothesis and Fama's formalisation

The early treatment of efficient market model was based on the Random Walk hypothesis, which contended that changes in security price occurred randomly. The statement that current price of the security fully reflect available information is assumed to imply that successive one-period returns are independent and identically distributed, constituting random walk model.

Successive one-period returns are independent and identically distributed. That phrase answers sample question 2 — under a random walk, successive price changes are independent.

Fama's fair game model

The early academic work in this area was mainly based on extensive empirical analysis. In 1970, Eugene Fama formalized the theory and organized the empirical evidences.

Fama presented the efficient market hypothesis in terms of a fair game model stating that in an efficient market, investors can be confident that the current market price fully reflects all available information about a security. Therefore, the expected return based upon this price is consistent with the risk of the security.

Hence by design or by using any investment strategy or tool, investors can't derive above average risk adjusted return. Investors should receive normal returns consistent with the risk they are taking.

Two names and one date to remember: Eugene Fama, 1970, the fair game model.

And note the precise claim. Efficiency does not say investors cannot earn good returns — it says they cannot earn above average RISK ADJUSTED returns. You may earn 30 per cent by taking the risk that ordinarily earns 30 per cent. What you cannot do is earn 30 per cent while bearing the risk of a 12 per cent asset.

In his original article, Fama divided the overall efficient market hypothesis (EMH) and the empirical tests of the hypothesis into three sub hypotheses depending on the information set involved: weak-form EMH; semi strong-form EMH and strong-form EMH.

The three forms differ only in one thing — the information set involved. That is the organising idea of the next section.

Think of it like this

The weighing scale that is never exactly right, but never leans one way

A shopkeeper's scale reads a little heavy on some weighings and a little light on others. Over a hundred sales the errors cancel out, and no customer can work out in advance which way today's reading will err. That scale is unbiased, though it is almost never exactly right.

Now consider a scale that always reads 20 grams light. It is biased, and a clever customer can exploit it every single time.

That is precisely the technical definition: an efficient market is one where the market price is an unbiased estimate of the true value of the security. It implies that in an efficient market, price of a security need not be equal to its true value, as long as deviations of the price from the value is random in nature.

And the consequence: no investor should be able to consistently find under-valued or over-valued securities using any investment strategy with the objective of generating abnormal return. Errors are permitted. Predictable errors are not.

Three circles of information at a village wedding

Some things about a family are known to everyone who has lived in the village for years — who married whom, which harvests were good. Some things are known to anyone who reads the notices at the panchayat office — the land registrations, the court cases. And some things are known only inside the house.

The three forms of efficiency are exactly these three circles. The weak form covers all historical information such as historical sequence of prices, rates of return, trading volume data. The semi-strong adds all publicly available information such as earnings announcements, dividend announcements, price-to-earnings (P/E) ratios... news about the economy, political news. The strong form adds insider information, too.

And each circle contains the smaller one: The semi-strong hypothesis encompasses the weak-form hypothesis, and the strong form encompasses the weak-form hypothesis as well as semi-strong-form hypothesis.

Reading yesterday's bus timings to predict tomorrow's traffic

If a bus arrives at random times, studying a month of arrival records tells you nothing about tomorrow morning. The pattern you think you see in the numbers is a pattern in the numbers, not in the buses.

That is the weak form's verdict on chart reading. Technical analysts use technical indicators using past price/return/volume data to predict the future price movement. If market is in weak form of efficiency, then analysing past information will not lead to identification of future price movements as past returns are not congruent with future returns.

The workbook does not soften it: EMH renders technical analysis completely irrelevant for superior returns.

And the reason is structural, not a matter of skill: current market price contains all prior information and it sufficiently provides information to the future state rather than all prior states combined. Today's price has already digested the whole history.

The shopkeeper who reads the newspaper — along with everyone else

A trader rises early, reads every newspaper and works out that cotton prices will rise. He rushes to the market at nine — and finds the price has already moved, because two hundred other traders read the same newspapers.

That is the semi-strong form. The semi-strong-form EMH asserts that security prices adjust rapidly and accurately to the release of all public information. Analysts conducting fundamental analysis determine the value of securities based on publicly available information. Therefore, if the market is tested to be in semi-strong form of efficiency, trading on the basis of publicly available information will not yield investors the chances of generating superior risk adjusted return considering that securities prices immediately reflect all such new public information.

Note the one door the workbook leaves open in this form: Cases of insider trading may crop up in this form of market, where investors who have information that is not public, tend to gain abnormal returns. Under semi-strong efficiency, only non-public information can still pay — which is exactly the conduct the law forbids.

The market that needs disbelievers to work

A queue at a temple counter moves fairly only because people keep checking whether another counter is faster. If everyone stopped checking, one counter would soon be far quicker than the rest — and the person who checked would be rewarded.

The workbook calls this the internal contradiction in the concept of efficiency: Markets do not become efficient on their own. It is the actions of participants, sensing profit maximizing opportunities and trading on the basis of information using some investment strategy to beat the market that makes markets efficient. Thus, the necessary conditions for a market to become efficient is the belief of the participants that market is not efficient and they can derive superior risk adjusted returns by using some schemes or strategies.

Stated plainly: to make the market efficient, a large number of profit maximizing participants should seek out opportunities of beating the market based on their belief that market is not efficient. Efficiency is the by-product of a great many people trying to defeat it.

When you cannot beat the bus, take the bus

A man who cannot reliably weave through traffic faster than the bus is better off taking the bus. He arrives at the same time as everyone else — but without the petrol, the parking charge and the risk of a dent.

That is the case for index funds, and the workbook makes it in cost terms rather than return terms: In an efficient market, a strategy of minimizing transaction costs would be superior to a strategy which requires frequent trading especially for investors with long term investment horizon. When it is difficult to beat the market, be with the market and reduce the transaction is the premise on which indexing is based on.

And the arithmetic that follows: Minimising transactions reduces transaction cost and tax implications thus making returns to be better to begin with. Note both savings — transaction cost AND tax implications. Two portfolios holding identical shares can end the decade far apart on turnover alone.

Key terms in this chapter

Case for Index Funds: In an efficient market, minimising transaction costs beats frequent trading, especially over long horizons — when it is difficult to beat the market, be with the market and reduce transactions, saving both transaction costs and tax.
External Anomalies: Predictable market responses to capital flows from central bank interest rate policy, economic factors and the financial calendar — in India, reduced liquidity from January to March owing to advance tax, year-end closings, government borrowing and balance sheet management by banks and NBFCs.
Fair Game Model: Fama's 1970 formulation: in an efficient market the current price fully reflects all available information, the expected return on that price is consistent with the security's risk, and no strategy can deliver above-average risk-adjusted returns.
Informational Efficiency: The sense in which market efficiency is usually meant — a market in which prices always fully reflect the most up to date current information, so that market price equals the fair value of securities.
Internal Contradiction in Efficiency: Markets do not become efficient on their own — efficiency is produced by many profit-maximising participants trading on information precisely because they believe the market is not efficient. This makes a deep and liquid market a prerequisite for efficiency.
Intrinsic Value: Also called fundamental value — the value investors would place on an asset if they had complete understanding of its investment characteristics. In practice it can only be estimated and is never known for certain.
Operational Efficiency: A measure of the cost of transacting in a market — transaction costs or impact cost. A market becomes operationally efficient as the cost of transacting falls.
Random Walk Hypothesis: The early model of efficiency, holding that changes in security prices occur randomly, so that successive one-period returns are independent and identically distributed.
Semi-strong-form Efficiency: Prices reflect all historical plus all publicly available information — earnings and dividend announcements, P/E, D/P and P/BV ratios, restructuring news, stock splits, economic and political news. It encompasses the weak form, and leaves room only for insider information to produce abnormal returns.
Size Anomaly: The finding that small firms, measured by total market value, consistently experience larger risk-adjusted returns than larger firms — a contradiction of market efficiency, and the direct origin of small cap portfolios.
Strong-form Efficiency: Prices reflect historical, public and insider information. It encompasses both weaker forms and contends that no group of investors can derive above-average risk-adjusted rates of return.
Unbiased Estimate: The technical definition of an efficient market price. Price need not equal true value, provided deviations are random, give an equal chance of under, over or fair valuation at any time, and are uncorrelated with any observable market variable.
Value Anomaly: The finding of a positive relationship between the book value to price ratio and future returns, with high book-to-price stocks generating superior risk-adjusted returns. Because that ratio is public information, it contradicts the efficient market hypotheses and underlies value investing.
Value Investing: The philosophy of purchasing assets at a discount to their intrinsic value, targeting stocks under-priced relative to fundamental value and gaining when the market corrects. Benjamin Graham established it in The Intelligent Investor in 1949; Warren Buffett is its most prominent modern practitioner.
Wash Sale: The deliberate booking of a loss so that it can be set off against capital gains made during the year. Common as tax arbitrage in the US market, it creates end-of-year selling pressure and the resulting January Anomaly.
Weak-form Efficiency: Prices fully reflect all historical information — the sequence of past prices, rates of return and trading volume data. Current prices are independent of past prices, so technical analysis yields little.

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Original explanatory writing based on the official NISM workbook for Series XIX-C, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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