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Tests of market efficiency are the joint tests of (1)the market is efficient and (2) expected return model.

Please help me (a) explain this and (b) is it possible to test market efficiency with either of these ones?

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  • $\begingroup$ I would suggest reading Fama's Original 1970 Paper on efficient market. That paper is not that difficult to read but very insightful. $\endgroup$
    – zsljulius
    Oct 12, 2015 at 21:45
  • $\begingroup$ See here: Joint Hypothesis Problem: "market efficiency per se is not testable." Nonetheless, we have strong hints that American stock markets seems pretty informationally efficient. $\endgroup$
    – Kevin
    May 28, 2022 at 12:12

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When markets are said to be efficient then the expectation is that there is no excess returns (alpha).

The expected return is basically a model of forecasting returns such as CAPM.

So basically you want to test if alpha (excess returns) is significant.

It's a joint test in the sense that you are not only testing alpha but are also testing the validity of CAPM to determine returns in the first instance.

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  • $\begingroup$ For example when Reinganum and Banz (1981) found that small cap stocks had higher returns than big cap stocks, there was a debate: if the CAPM is right, this is an inefficiency, but perhaps small cap stocks have special risks that the CAPM does not properly take into account; if so the market is efficient but the CAPM is flawed and needs to be amended accordingly. This debate persists even today... $\endgroup$
    – nbbo2
    May 28, 2022 at 17:39

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