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The Efficient Market Hypothesis (EMH) isn't just an abstract theory—it's the foundation for understanding how prices are set, why active management struggles to beat the market, and what investment strategies actually make sense. You're being tested on your ability to explain why markets might be efficient, what conditions must hold for efficiency to exist, and when these assumptions break down in the real world. Expect exam questions that ask you to evaluate whether a given scenario violates EMH assumptions or to explain why certain trading strategies shouldn't generate consistent excess returns.
Don't just memorize these ten assumptions as isolated facts. Instead, understand how they cluster into three testable themes: information flow and processing, market structure and competition, and frictionless trading conditions. When you can identify which category an assumption belongs to—and explain how violating it creates opportunities for abnormal returns—you've mastered the conceptual thinking that earns top scores on FRQs.
These assumptions address how information enters the market and how investors respond to it. The core principle: if everyone receives the same information simultaneously and processes it rationally, no one can gain an edge.
Compare: Equal Access to Information vs. Instantaneous Price Adjustment—both address information, but the first concerns who gets it while the second concerns how fast prices respond. If an FRQ asks why insider trading is profitable, point to violations of equal access; if it asks about event studies, focus on adjustment speed.
These assumptions describe the competitive environment that prevents any single player from distorting prices. The core principle: with many participants and no dominant actors, prices reflect collective wisdom rather than individual manipulation.
Compare: Large Number of Participants vs. No Single Investor Dominates—the first addresses quantity of market actors, the second addresses power distribution. A market could theoretically have many participants but still be dominated by a few large institutions, violating the second assumption while satisfying the first.
These assumptions remove real-world obstacles that could prevent prices from reaching equilibrium. The core principle: without costs or barriers, arbitrageurs can instantly correct any mispricing.
Compare: No Transaction Costs vs. High Liquidity—both reduce trading friction, but costs are explicit barriers (fees, taxes) while liquidity concerns market depth (ability to trade without moving prices). In practice, illiquid markets can have low transaction costs but still be inefficient.
These assumptions describe the outcomes that emerge when all other conditions hold. The core principle: efficient markets produce prices that equal fair value, with any deviations quickly corrected.
Compare: Price Equals Fair Value vs. Rapid Arbitrage Elimination—fair value pricing is the outcome of efficiency, while arbitrage elimination is the mechanism that enforces it. FRQs often ask you to explain the process: arbitrageurs identify mispricings → execute trades → prices converge to fair value.
| Concept | Key Assumptions |
|---|---|
| Information Distribution | Equal access to information, Instantaneous price adjustment |
| Investor Behavior | Rational profit maximization, Homogeneous expectations |
| Market Competition | Large number of participants, No dominant investors |
| Trading Friction | No transaction costs/taxes, High liquidity |
| Price Outcomes | Price equals fair value, Rapid arbitrage elimination |
| Real-World Violations | Behavioral biases, Information asymmetry, Transaction costs |
Which two assumptions most directly explain why insider trading would be profitable if EMH didn't hold?
If a market has many participants but one hedge fund controls 40% of trading volume, which specific EMH assumption is violated and why does this matter for price accuracy?
Compare and contrast the roles of "rational investor behavior" and "homogeneous expectations"—could a market satisfy one assumption but not the other?
An FRQ describes a market with high transaction costs where obvious mispricings persist for weeks. Identify which two assumptions are violated and explain the causal chain connecting them.
Why is the "rapid arbitrage elimination" assumption considered a mechanism rather than a condition? What other assumptions must hold for arbitrage to function effectively?