ORI GI NAL RESEARCH

Analysis of efcient markets

Arie Harel

Giora Harpaz

Jack Clark Francis
Published online: 20 April 2010
Springer Science+Business Media, LLC 2010
Abstract A simple trading model is presented in which Bayes rule is used to aggregate
traders forecasts about risky assets future returns. In this nancial market, Bayes rule
operates like an omnipotent market-maker performing functions that in 1776 Adam Smith
attributed to an invisible hand. We have analyzed two distinct cases: in the rst scenario,
the traders forecast errors are uncorrelated, and in the second scenario, the traders
forecast errors are correlated. The contribution of our paper is fourfold: rst, we prove that
the efcient market mean-return can be expressed as a complex linear combination of
the traders forecasts. The weights depend on the forecast variances, as well as on the
correlations among the traders forecasts. Second we show that the efcient variance is
equal to the inverse of the sum of the traders precision errors, and is also related to the
correlations among the traders forecast errors. Third, we prove that the efcient market
return is the best linear minimum variance estimator (BLMVE) of the securitys mean
return (in the sense that it minimizes the sum of the traders mean squared forecast errors).
Thus, an efcient market aggregates traders heterogeneous information in an optimal way.
Fourth, we prove that an efcient market produces a mean return (price) as a Blackwell
sufcient (most informative) experiment among all possible aggregated expected return
(price) forecasts.
Keywords Asset pricing, Bayesian analysis Information Market efciency
Mathematics Subject Classication (2000) 91B06 91B28 62C10
JEL Classications C11 G14 G10
A. Harel (&) G. Harpaz J. C. Francis
The Zicklin School of Business, Baruch College, City University of New York, One Bernard Baruch
Way, 55 Lexington Avenue, New York, NY 10010-5585, USA
e-mail: arie.harel@baruch.cuny.edu
G. Harpaz
e-mail: giora.harpaz@baruch.cuny.edu
J. C. Francis
e-mail: Jack@JCFrancis.com
1 3
Rev Quant Finan Acc (2011) 36:287296
DOI 10.1007/s11156-010-0178-z
1 Introduction
The Efcient-Market Hypothesis (hereafter EMH) in nancial economics asserts that
nancial markets are informationally efcient, in other words, security prices and returns
fully reect all information. Hence, market prices and returns are unbiased in the sense that
they reect the collective beliefs of all investors regarding future prices (and returns), and no
investor can earn excess returns using available information. Bachelier (1900), in his
famous thesis, was the rst who contended that stock prices follow a random walk. His
contribution remained largely unknown for many years until it was translated to English and
published in Cootner (pp. 1778). The EMH emerged as a prominent theory in nancial
economics in the mid-1960s, advanced by Fama (1970) in his seminal doctoral dissertation,
and was tested empirically. Famas empirical research supported the hypothesis that stock
prices tend to follow a random walk. He became the driving force in conducting various
empirical tests of the validity of the EMH, and was followed by many others. In two
excellent and highly cited studies Fama (1970, 1991) reexamined both the theory and the
empirical evidence of the EMH. He contended that there are three ordinary forms in which it
can be stated: weak-form efciency, semi-strong efciency, and strong-from efciency,
each of which have different implications for how capital markets function. First, weak-
form efciency argues that no excess returns can be obtained by using investment strategies
based on historical security prices (returns). Next, semi-strong form efciency suggests that
prices (returns) adjust instantaneously and in an unbiased manner to publicly available
information, so that no excess return can be obtained by trading on this information. Finally,
strong-from efciency asserts that security prices (returns) reect all information, public
and private, and no investor can earn excess returns by trading on this information. In a
popular book Malkiel (2003), a highly regarded proponent of the soundness of the EMH,
provided a comprehensive summary of the pros and cons of the theory and its implications
for investors. A recent study by Lee and Yen (2008) provides an excellent summary of the
past, present and future of the empirical evidence bearing on the EMH.
In three important theoretical studies by Grossman (1976), and Grossman and Stigliz
(1976, 1980), it was argued that if the market prices reveal all information for free, there
would be no longer incentives for traders to privately invest in information gathering. If no
one invests in information gathering, then the market price cannot reveal all available
information. This is called the EMH paradox. Thus, any one investor can be wrong about
the market, but the market as whole is always right. They argued, however, that the capital
market should have some noise factors that prevent investors from correctly inferring the
private information signals of others, resulting in asset prices that are less than fully
revealing.
This paper is different from the Grossman (1976) study as is it concerned with the
microstructure of the capital market. We study the aggregation of traders diverse infor-
mation and the implications for the resulting efcient return. A simple trading model is
presented in which the capital market aggregates traders heterogeneous information in a
Bayesian manner (DeGroot 1970; Winkler 1981; Lee 2004). Traders possess apriori
information about each risky assets unknown future mean return. An omnipotent market-
maker that can use all traders information sets combines all of these forecasts, via Bayes
rule, into an aggregate set of efcient mean returns (prices). The characteristics of the
efcient mean return are explored separately, when traders forecast errors are assumed to
be either uncorrelated or correlated.
The rest of the paper is organized as follows. Section 2 introduces a simple trading
model in which traders forecasts of risky assets future returns are uncorrelated and
288 A. Harel et al.
1 3
aggregated via Bayes rule. Section 3 derives the analytical results and analyzes the
properties of the resulting efcient mean returns. Section 4 proves that the efcient
mean return is a Blackwell (1951, 1953) sufcient experiment. Section 5 derives the
efcient market mean-returns (prices) when traders forecast errors are correlated. Sec-
tion 6 provides conclusions.
2 The trading model
The trading model is reduced to the minimum necessary complexity for the sake of clear
exposition, but without loss of generality. The capital market is populated by a nite number
of traders (n C 1) that consider trading risky assets that have unknown end-of-period returns
R. Due to the large size of the market (n is very large), each trader is assumed to possess only
a tiny fraction of the total initial capital. As a result, even the wealthiest trader is not large
enough to inuence the market outcomes using his/her own capital.
Traders use current information to forecast future asset-returns. It is assumed the traders
form their expectations in a Bayesian manner (DeGroot 1970; Winkler 1981; Lee 2004,
and more recently Harel et al. 2010). Thus their initial information is formally represented
by a prior distribution on the mean of R that is based, presumably, on preceding experience
with similar assets or on subjective assessment of the relevant mean return. The Bayesian
traders combine their apriori information with observations regarding the assets returns to
form the posterior distributions on which future decisions can be made. Each trader enters
the market with a non-informative (vague) prior probability distribution function (pdf) on
the unknown (random variable) return R. During the trading, but before the resolution of
uncertainty regarding the market return R, traders possess private information sets I
i
; i =
1; . . .; n: A particular traders information set can be formed from previous experience or
based on subjective assessment of the risky assets returns. This information can be gen-
erated from both private and public sources. The traders form their trades on the basis of
their prior pdfs on R, where g
i
(R
i
|I
i
) is the prior pdf of trader i contingent on his/her own
information set I
i
, which is a normal distribution with mean R
i
and variance r
i
2
. Based on
his/her unique information set I
i
, the ith traders forecast, R
i
, is an unbiased estimate or R,
i.e., R
i
= E(R) for i = 1; . . .; n: Therefore, the ith traders forecast error e
i
is:
R
i
R = e
i
; i = 1; . . .; n (1)
It is assumed that the traders expected forecast errors are zero, E(e
i
) = 0, with
Var(e
i
) = r
i
2
, and traders possess heterogeneous expectations. In this section, traders fore-
cast errors are assumed to be uncorrelated, i.e., Cov(e
i
, e
j
) = 0, for i = j and i; j = 1; . . .; n:
The rst trader forms his trading strategy based on his prior pdf for R, which is assumed
normal with mean R
1
and variance r
1
2
. Thus, before the forecast of type i traders R
i
; i =
2; . . .; n are known to him, the rst traders pdf is given by,
g(R[R
1
) exp
(R R
1
)
2
2r
2
1
_ _
(2)
The likelihood function is proportional to

n
i=2
g(R
i
[R; R
1
); thus,
l(R
2
; . . .; R
n
[R; R
1
) exp

n
i=2
(R R
i
)
2
2r
2
i
_ _
(3)
Analysis of efcient markets 289
1 3
The posterior pdf of R given all other traders forecasts, R
1
; . . .; R
n
( ); is proportional to the
product of rst traders prior pdf in Eq. 2, and the likelihood function l R
2
; . . .; R
n
[R; R
1
( ) in
Eq. 3, that is,
g(R[R
1
; . . .; R
n
) g(R[R
1
)l(R
2
; . . .; R
n
[R; R
1
) (4)
Hence, the posterior pdf of R in Eq. 4 can be expressed as:
g(R[R
1
; . . .; R
n
) exp
1
2

n
i=1
(R R
i
)
2
r
2
i
_ _
(5)
3 The efcient market returns
This section investigates the characteristics of the posterior pdf in Eq. 5, and derives the
efcient market mean returns l
eff
, and its corresponding standard deviation, r
eff
.
Recently, Yee (2008) discussed a Bayesian framework for equity valuation by combining
two or more estimates into superior valuation estimates in the spirit of our paper.
Theorem 1 The posterior pdf of R is normal with mean-return l
eff
= A/B, and return-
variance r
2
eff
= 1
_
n
i=1
r
2
i
; where the expressions are dened as: A =

n
i=1
R
i

j,=i
r
2
j
;
B =

n
i=1

j,=i
r
2
j
and C =

n
i=1
R
2
i

j,=i
r
2
j
:
Proof The posterior pdf of R in Eq. 5 can be expressed as:
exp
1
2

n
i=1
(R R
i
)
2
r
2
i
_ _
= exp
1
2

n
i=1
r
2
i

n
i=1
(R
2
2RR
i
R
2
i
)

j,=i
r
2
j
_ _
= exp
B
2

n
i=1
r
2
i
R
2

2RA
B

C
B
_ _ _ _
= exp
B
2

n
i=1
r
2
i
R
A
B
_ _
2

C
B

A
B
_ _
2
_ _ _ _
= exp
B
2

n
i=1
r
2
i
C
B

A
B
_ _
2
_ _ _ _
exp
B
2

n
i=1
r
2
i
R
A
B
_ _
2
_ _
exp
1
2
R
A
B
_ _
2
B

n
i=1
r
2
i
_ _
= exp
(R A=B)
2
2

n
i=1
1=r
2
i
_ _
1
_ _
The penultimate step follows since exp(k) exp() exp() when k is a constant. The last
step follows since B
_
n
i=1
r
2
i
=

n
i=1
1=r
2
i
:
290 A. Harel et al.
1 3
Theorem 1 has three interesting interpretations. First, one can consider the mean
return l
eff
produced by an efcient market to be the outcome of an aggregation of all
traders information by an omnipotent market-maker who observes and uses all informa-
tion. This know-it-all market-maker combines all traders apriori beliefs via Bayes rule, to
generate the efcient-market mean-return l
eff
. It should be pointed out that the aggre-
gation of traders diverse information into an efcient mean-return l
eff
is consistent with
the EMH. The issue is: What kind of information do traders have? If traders possess both
private information and public information, then our efcient market will be strongly
efcient. However, if traders only possess historical (public) information, then our nan-
cial market would be only weakly (semi-strongly) efcient. Whatever the relevant infor-
mation traders have (public or private) it will be fully reected in market prices and
returns, as suggested by the research conducted by Fama (1965, 1970, 1991), Malkiel
(2003), Lee and Yen (2008) and the studies cited by them. Moreover, the efcient
meanreturn l
eff
can be expressed as a linear combination of the traders forecasts:
l
eff
=

n
i=1
w
i
R
i
; where R
i
is the ith traders forecast, and w
i
is the weight associated with
that forecast. Any particular weight w
i
is a complex function of all traders forecast error
variances. Second, the efcient market return-variance r
2
eff
= 1=

n
i=1
1=r
2
i
is inversely
related to the sum of the traders precisions (the precisions are the reciprocal of the
variances, e.g., DeGroot 1970, p. 38). From a market point of view, it is appropriate for
traders with small forecast errors to be weighted more heavily. Third, another important
factor that affects the prices (returns) of assets traded by n traders is each traders initial
capital. A trader with a signicant amount of trading capital, but a large forecast error, will
be able to push the asset price above or below its efcient price. But, in our nancial
market, it is assumed that no trader has sufcient capital to alter an assets equilibrium
price (return).
The capability of the capital market to aggregate traders heterogeneous information can
be demonstrated for a specic case. Consider, for example, a capital market populated by
only three traders, n = 3. In this market, the normal posterior pdf of random variable R is
N(l
eff
, r
eff
2
), with an efcient mean-return l
eff
which is a linear combination of the three
traders forecasts,
l
eff
=
R
1
r
2
2
r
2
3
R
2
r
2
1
r
2
3
R
3
r
2
1
r
2
2
r
2
2
r
2
3
r
2
1
r
2
3
r
2
1
r
2
2
;
where the corresponding weights are: w
1
= r
2
2
r
2
3
=(r
2
2
r
2
3
r
2
1
r
2
3
r
2
1
r
2
2
); w
2
=
r
2
1
r
2
3
=(r
2
2
r
2
3
r
2
1
r
2
3
r
2
1
r
2
2
); w
3
= r
2
1
r
2
2
=(r
2
2
r
2
3
r
2
1
r
2
3
r
2
1
r
2
2
); for the rst, second and
third traders, respectively. Concurrently, the efcient return-variance is given by: r
2
eff
=
[r
2
1
r
2
2
r
2
3
[
1
; which is the inverse of the sum of the traders precisions.
Next, the second theorem proves that the mean return l
eff
generated by an efcient
market is a minimum variance estimator given the traders forecast errors. Hence, we
would like to minimize the expected value of the traders weighted average squared
prediction errors, E

n
i=1
k
i
e
i
_
2
=

n
i=1
k
2
i
r
2
i
(where E is the expectation operator), with
respect to the constants k
1
; . . .; k
n
; (k
i
_0; i = 1; . . .; n): Note that (by the initial
assumption) the traders prediction errors are uncorrelated, Cov(e
i
, e
j
) = 0, for i = j and
i; j = 1; . . .; n: Correlated forecast errors are considered in Sect. 5.
Theorem 2 The efcient market return is the best linear minimum variance estimator
(BLMVE) of the securitys expected return. Thus, the values of k
1
; . . .; k
n
that minimize

n
i=1
k
2
i
r
2
i
subject to

n
i=1
k
i
= 1 where k
i
C 0, i = 1; ::; n are:
Analysis of efcient markets 291
1 3
k
i
=

j,=i
r
2
j
B
=

j,=i
r
2
j

n
i=1

j,=i
r
2
j
Proof Expressing k
n
= 1

n1
i=1
k
i
and taking the derivative of

n
i=1
k
2
i
r
2
i
with respect
to k
i
; i = 1; . . .; n 1 and equating to zero gives 2k
i
r
2
i
2 1

n1
i=1
k
i
_ _
r
2
n
= 0; i =
1; . . .; n 1: Solving this set of equations plus the equation

n
i=1
k
i
= 1 yields the
result. j
Consider, for example, a capital market populated by two traders, n = 2. In this market,
the efcient mean return l
eff
= (R
1
r
2
2
R
2
r
2
1
)=(r
2
1
r
2
2
); is a linear combination of the
two traders forecasts, and it is easy to verify from Theorem 2 that the efcient market
would produce the optimal weights: k
1
= r
2
1
=(r
2
1
r
2
2
) and k
2
= r
2
2
=(r
2
1
r
2
2
): That is,
the efcient market return is the BLMVE of the securitys expected return.
4 Blackwell Sufciency
Consider a security market in which trading takes place by Bayesian traders described in
the previous section. Let M
t
= [R[R~N(l; r
2
)[ be a family of experiments in each period t
(where l is the unknown mean, and r is known), in the sense of Blackwell (1951, 1953).
Suppose that in each period t the aggregate market returns are derived by two experiments
X, Y [ M
t
, where X is the return produced by an efcient market, and Y is another (not
necessarily efcient) aggregate market return. Blackwell (1951) proved that X is more
informative than Y (or X is sufcient for Y) if there exists a stochastic transformation of X
onto Y independent of the unknown parameter.
Proposition 1 Let X be N(l; r
2
) and Y be N(l, cr
2
), where l is the unknown mean
return, r is the known standard deviation, and c [1. Then the experiment X is sufcient
for Y.
Proof In our security market, the Blackwell stochastic transformation is given by,
Y = X ? Z, where Z * N[0, (c - 1)r
2
] is independent of X and l. Hence, X is sufcient
for Y. j
Intuitively, if someone has access to the experiment X, he can reproduce the experiment
Y using a stochastic transformation from X to Y. Thus, by using the observations from the
experiment X, one can do at least as well as by using the observations from Y for every
decision and inference. Theorem 2 claims that the efcient market return is the BLMVE of
the securitys expected return. Proposition 1 conrms that it is also Blackwell-sufcient for
any other aggregate market mean returns.
5 Correlated forecast errors
For the sake of clarity and for the ease of mathematical exposition, Eq. 1 assumed that
traders forecast errors are uncorrelated, i.e., Cov(e
i
, e
j
) = 0, for i = j, i; j = 1; . . .; n: This
assumption simplies reality. The prices of some assets form bubbles that burst, often
disrupting the surrounding economy. These bubbles are often associated with strong cor-
relations among traders forecasting errors. For example, Japans stock market peaked in
292 A. Harel et al.
1 3
late 1989 and then declined into an extended recession during which traders forecasts
were positively correlated. The U.S. stock markets Dot.com bubble peaked in 2000 and
then fell into a recession as traders forecast moved in tandem. Furthermore, the price of
crude oil rose during 20062007 to a world-wide peak that burst and fell during 2008.
Positively correlated oil forecasts characterized the crude oil price rise from $45 per barrel
in 2006 to a peak of $145 and the precipitous drop back to $45 in 2008. In this section we
analyze the implications for the EMH and asset returns if strong correlations among traders
forecasts exist (Winkler 1981). In contrast to Eq. 1, this section considers the case when
Cov(e
i
, e
j
) = r
ij
= 0, for i; j = 1; . . .; n; and i = j. Let e = (e
1
; . . .; e
n
)
/
be an n
dimensional random variable vector of forecast errors. (Hereafter, vectors will be denoted
by over-bar signs, and should be assumed to be columns, unless they are primed). A prime
sign indicates a transposition. Then, random variable e is distributed multivariate normal
(DeGroot 1970, pp. 5159)
e ~N(

0; X
nxn
) (6)
with an n-dimensional zero mean vector (0,,0)
/
and a non-singular variance/covariance
matrix X
n9n
= (r
ij
), i, j = 1,,n. The posterior pdf g(R[ r) of R given the traders vector
of forecasts r = (R
1
; . . .; R
n
)
/
is proportional to the n-traders joint likelihood function,
g(R[ r) l(R
1
R; R
2
R; . . .; R
n
R);
it can be written as:
g(R[ r) exp
1
2
r Ru ( )
/
X
1
( r R u)
_ _
; (7)
where u = (1; . . .; 1)
/
is an ndimensional unit vector. It should be noted that if the
traders forecast errors are uncorrelated the variancecovariance matrix X
n9n
in Eq. 7
becomes an n 9 n diagonal matrix D
r
= diag(r
1
2
,,r
n
2
), and the corresponding posterior
pdf will be identical to the one in Eq. 5.
In order to nd the mean and variance of the posterior pdf in Eq. 7, we use the concept
of Bayes estimator. Bayes Estimators are admissible estimators, and by the denition of an
admissible estimator, it has minimum risk compared to any other estimators (DeGroot
1970, Ch.11). If we use a quadratic loss function (such as the MSE), the Bayes estimator
will also have minimum variance (BLMVE). Using the MSE as the loss function, the
Bayes estimator produces the posterior pdfs mean g
eff
, and the minimum MES (Bayes
risk) is the posterior pdfs variance d
eff
2
. In Theorem 3, we derive the Bayes estimator, and
examine its characteristics.
Theorem 3 When traders forecast errors are correlated, the efcient market mean-
return is: g
eff
= ( u
/
X
1
r)=( u
/
X
1
u), with a corresponding return-variance: d
2
eff
=
( u
/
X
1
u)
1
:
Proof In order to nd the posterior pdfs mean and variance in Eq. 7, we derive the
Bayes estimator. We can derive the optimal weights which minimize the traders Mean
Square Error (MSE) of their weighted average unbiased forecasts. These optimal weights
are expressed in terms of the variances of the forecast errors, which minimize the MSE. Let
a be an ndimensional vector of weights, X
n9n
is a non-singular variancecovariance
matrix of the n traders forecast errors, and V(a
+
) be the variance associated with a
particular vector of weights a
+
. The constrained MSE minimization problem can be stated
as:
Analysis of efcient markets 293
1 3
Min (a
/
Xa) subject to : a
/
u = 1;
where the minimization is with respect to a: Dene the Lagrange function L as: L =
(a
/
Xa) k(a
/
u 1); where k is the Lagrange multiplier. The rst order conditions for
minimization are: oL=oa = 2a
/
X ku = 0; and oL=ok = a
/
u 1 = 0; and the second
order condition is clearly satised: o
2
L=oa
2
= 2X[0 (as long as not all forecast errors are
perfectly correlated). Multiplying the rst order equations by ( u
/
X
1
)=2 and rearranging
gives u
/
a = (k=2) u
/
X
1
u) = 1; hence the Lagrange multiplier is: k = 2( u
/
X
1
u)
1
:
Substituting k = 2( u
/
X
1
u)
1
into the rst order condition and multiplying by X
-1
gives
the optimal weighting vector, a
eff
= ( u
/
X
1
u)
1
X
1
u: Therefore, the minimum MSE is:
V(a
eff
) = (a
/
eff
Xa
eff
) = ( u
/
X
1
u)
1
= d
2
eff
; which is the efcient market return-variance.
In conjunction, the efcient market mean-return is a weighted average of the traders
forecast errors, i.e., g
eff
= a
/
eff
r = ( u
/
X
1
r)=( u
/
X
1
u): Thus, the posterior pdf of R in Eq. 7
is normal, R * N(g
eff
, d
eff
2
). j
Thus, when traders forecasts are correlated, the efcient market mean-return (Bayes
estimator) will be a linear combination of the traders forecasts, which is affected by both
the traders forecast variances and their correlations. Moreover, the efcient market return-
variance is equal to the inverse of the sum of the traders precision errors, and, is also
related to the correlations among the traders forecast errors.
These relationships can also be expressed by using the correlation matrix. Let C
nn
=
(q
ij
); i; j = 1; . . .; n; where q
ij
are the correlations between the forecast errors of the ith and
jth traders. Let X
n9n
and C
n9n
be the variance/covariance and correlation matrixes,
respectively, then X = D
r
CD
r
, where D
r
= diag(r
1
2
,,r
n
2
) and r
ij
, i; j = 1; . . .; n are the
typical elements of X
n9n
.
Consider a nancial market populated by only two traders, i.e., n = 2. In this case, the
variancecovariance matrix is:
X
22
=
r
2
1
; qr
1
r
2
qr
2
r
1
; r
2
2
_ _
; u
/
= 1; 1 ( ); r
/
= R
1
; R
2
( );
q is the correlation between the traders forecast errors, and the inverse variancecovari-
ance matrix is:
X
1
22
=
1
r
2
1
(1q
2
)
;
q
r
1
r
2
(1q
2
)

q
r
1
r
2
(1q
2
)
;
1
r
2
2
(1q
2
)
_ _
:
Note that traders forecasts cannot be perfectly correlated. A value of q
2
\1 is needed to
keep the asset returns (prices) from going to innity or zero if all traders have identical (or
inverse) forecasts. Thus, the efcient market mean-return
g
eff
= a
/
eff
r = ( u
/
X
1
r)=( u
/
X
1
u)
=
(1; 1)
1
r
2
1
(1q
2
)
;
q
r
1
r
2
(1q
2
)

q
r
1
r
2
(1q
2
)
;
1
r
2
2
(1q
2
)
_ _
R
1
R
2
_ _
(1; 1)
1
r
2
1
(1q
2
)
;
q
r
1
r
2
(1q
2
)

q
r
1
r
2
(1q
2
)
;
1
r
2
2
(1q
2
)
_ _
1
1
_ _
(8)
294 A. Harel et al.
1 3
=
1
r
2
1
(1q
2
)

q
r
1
r
2
(1q
2
)
;
q
r
1
r
2
(1q
2
)

1
r
2
2
(1q
2
)
_ _
R
1
R
2
_ _
1
r
2
1
(1q
2
)

q
r
1
r
2
(1q
2
)
;
q
r
1
r
2
(1q
2
)

1
r
2
2
(1q
2
)
_ _
1
1
_ _
=
R
1
1
r
2
1
(1q
2
)

q
r
1
r
2
(1q
2
)
_ _
R
2

q
r
1
r
2
(1q
2
)

1
r
2
2
(1q
2
)
_ _
1
r
2
1
(1q
2
)

q
r
1
r
2
(1q
2
)

q
r
1
r
2
(1q
2
)

1
r
2
2
(1q
2
)
=
R
1
1
r
2
1

q
r
1
r
2
_ _
R
2
1
r
2
2

q
r
1
r
2
_ _
1
r
2
1

1
r
2
2

2q
r
1
r
2
: (9)
Likewise, the efcient market return-variance is given by,
d
2
eff
= (a
/
eff
Xa
eff
) = ( u
/
X
1
u)
1
= (1;1)
1
r
2
1
(1q
2
)
;
q
r
1
r
2
(1q
2
)

q
r
1
r
2
(1q
2
)
;
1
r
2
2
(1q
2
)
_ _
1
1
_ _
_ _
1
=
1
r
2
1
(1 q
2
)

2q
r
1
r
2
(1 q
2
)

1
r
2
2
(1 q
2
)
_ _
1
: (10)
If the traders forecast errors are uncorrelated (as in Sects. 2 and 3), then q = 0, and the
efcient market mean-return is simply a weighted average of the traders forecasts, where
the weights are the traders precision errors,
l
eff
=
R
1
=r
2
1
R
2
=r
2
2
1=r
2
1
1=r
2
2
=
R
1
r
2
2
R
2
r
2
1
r
2
1
r
2
2
:
Similarly, the efcient market return-variance is reduced to the reciprocal of the traders
precision errors, r
eff
2
= [1/r
1
2
? 1/r
2
2
]
-1
.
6 Conclusions
The paper explores a simple trading model which aggregates traders diverse information
regarding a risky assets future return. Conceptually, we can think about the existence of an
omnipotent market-maker that observes all traders private information sets. This know-it-
all market maker uses Bayes rule to aggregate the information from all traders forecasts
into an efcient set of mean returns (prices). Adam Smiths (1776) invisible hand
concept is appropriate here. An invisible hand process is one in which the outcome to be
explained is produced in a decentralized way, with no explicit agreements between the
government and the investors. The second essential ingredient is that the process is not
intentional. The investors activities are neither coordinated nor are they identical with the
actual price outcome that is a byproduct of those activities. The process should work
without investors having any knowledge of it. This is why the process is called invisible.
We interpret the outcome as an efcient market price.
The contribution of our paper is in investigating the characteristics of the efcient
mean-return, as proved in three major theorems. The rst theorem proves that the mean
return generated by an efcient market is a linear combination of the n- traders forecasts,
Analysis of efcient markets 295
1 3
where the weights are related, in a complex way, to the variances of their forecast errors, as
well as the correlations among their forecasts. Concurrently, the efcient variance is
computed and shown to be equal to the inverse of the sum of the traders precisions (the
reciprocals of their prediction variances) and is, also, related to the correlations among the
traders forecasts. The second theorem proves that the mean return generated by an ef-
cient capital market is the best linear minimum variance estimator (BLMVE) that can be
derived from the traders forecasts, that minimizes their mean squared forecast errors.
Thus, the capital market aggregates traders heterogeneous information (about the risky
assets unknown future returns) in an optimal manner. A different interpretation of the
aggregation power of an efcient market is that it produces a mean return as a Blackwell
sufcient experiment (Blackwell 1951, 1953). It is proved that the efcient market mean
return (price) is also the most informative experiment among all possible aggregate market
mean returns (prices). The EMH states that it is impossible to consistently outperform the
market by using information that the market already knows, except through luck. Our
results are consistent with the EMH (Fama 1965, 1970, 1991, and his followers), whereby
security prices (and returns) fully reect all relevant information. If the traders infor-
mation sets also include inside information, then our efcient market will be strongly
efcient. However, if the traders information set include only public (historical) infor-
mation, our efcient market would be only semi-strongly (weakly) efcient.
Acknowledgments The authors are grateful to the referees for their critical reading of the paper and for
many helpful comments and suggestions which have improved the quality of the paper.
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