efficiency

Tests of market efficiency look at the whether specific investment strategies earn

excess returns. Some tests also account for transactions costs and execution feasibility.

Since an excess return on an investment is the difference between the actual and expected

return on that investment, there is implicit in every test of market efficiency a model for this

expected return. In some cases, this expected return adjusts for risk using the capital asset

pricing model or the arbitrage pricing model, and in others the expected return is based

upon returns on similar or equivalent investments. In every case, a test of market efficiency

is a joint test of market efficiency and the efficacy of the model used for expected returns.

When there is evidence of excess returns in a test of market efficiency, it can indicate that

markets are inefficient or that the model used to compute expected returns is wrong or both.

While this may seem to present an insoluble dilemma, if the conclusions of the study are

insensitive to different model specifications, it is much more likely that the results are being

driven by true market inefficiencies and not just by model misspecificatio