Financial market efficiency
Encyclopedia
In the 1970s Eugene Fama
defined an efficient financial market as "one in which prices always fully reflect available information”.
The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.
This includes producing the right goods for the right people at the right price.
A trait of allocatively efficient financial market is that it channels funds from the ultimate lenders to the ultimate borrowers in a way that the funds are used in the most socially useful manner.
1. Weak-form efficiency
Prices of the securities instantly and fully reflect all information of the past prices. This means future price movements cannot be predicted by using past prices.
2. Semi-strong efficiency
Asset
prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have advantage on the market.
3. Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no one can have advantage on the market in predicting prices since there is no data that would provide any additional value to the investors.
(EMH) theory, which states that in any given time, the prices on the market already reflect all known information, and also change fast to reflect new information.
Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck.
is the “random walk
” theory, which states that the prices in the financial markets evolve randomly and are not connected, they are independent of each other.
Therefore, identifying trends or patterns of price changes in a market couldn’t be used to predict the future value of financial instruments
.
identified four efficiency types that could be present in a financial market:
1. Information arbitrage
efficiency
Asset prices fully reflect all of the privately available information (the least demanding requirement for efficient market, since arbitrage includes realizable, risk free transactions)
Arbitrage involves taking advantage of price similarities of financial instruments between 2 or more markets by trading to generate losses.
It involves only risk-free transactions and the information used for trading is obtained at no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that arbitrage is a result of market inefficiency.
This reflects the weak-information efficiency model.
2. Fundamental valuation efficiency
Asset prices reflect the expected past flows of payments associated with holding the assets (profit forecasts are correct, they attract investors)
Fundamental valuation involves lower risks and less profit opportunities. It refers to the accuracy of the predicted return on the investment.
Financial markets are characterized by predictability and inconsistent misalignments that force the prices to always deviate from their fundamental valuations.
This reflects the semi-strong information efficiency model.
3. Full insurance efficiency
It ensures the continuous delivery of goods and services in all contingencies.
4. Functional/Operational efficiency
The products and services available at the financial markets are provided for the least cost and are directly useful to the participants.
Every financial market will contain a unique mixture of the identified efficiency types.
. While most financiers believe the markets are neither 100% efficient, nor 100% inefficient, many disagree where on the efficiency line the world's markets fall.
It can be concluded that in reality a financial market can’t be considered to be extremely efficient, or completely inefficient.
The financial markets are a mixture of both, sometimes the market will provide fair returns on the investment for everyone, while at other times certain investors will generate above average returns on their investment.
Eugene Fama
Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...
defined an efficient financial market as "one in which prices always fully reflect available information”.
The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.
This includes producing the right goods for the right people at the right price.
A trait of allocatively efficient financial market is that it channels funds from the ultimate lenders to the ultimate borrowers in a way that the funds are used in the most socially useful manner.
Market efficiency levels
Eugene Fama identified three levels of market efficiency:1. Weak-form efficiency
Prices of the securities instantly and fully reflect all information of the past prices. This means future price movements cannot be predicted by using past prices.
2. Semi-strong efficiency
Asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have advantage on the market.
3. Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no one can have advantage on the market in predicting prices since there is no data that would provide any additional value to the investors.
Efficient Market Hypothesis (EMH)
Fama also created the Efficient Market HypothesisEfficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...
(EMH) theory, which states that in any given time, the prices on the market already reflect all known information, and also change fast to reflect new information.
Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck.
Random Walk theory
Another theory related to the efficient market hypothesis created by Louis BachelierLouis Bachelier
-External links:** Louis Bachelier webpage at the Université de Franche-Comté, Besançon / France. Text in French.** also from Index Funds Advisors, this discussion of...
is the “random walk
Random walk
A random walk, sometimes denoted RW, is a mathematical formalisation of a trajectory that consists of taking successive random steps. For example, the path traced by a molecule as it travels in a liquid or a gas, the search path of a foraging animal, the price of a fluctuating stock and the...
” theory, which states that the prices in the financial markets evolve randomly and are not connected, they are independent of each other.
Therefore, identifying trends or patterns of price changes in a market couldn’t be used to predict the future value of financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
.
Evidence of Financial Market Efficiency
- Predicting future asset prices is not always accurate (represents weak efficiency form)
- Asset prices always reflect all new available information quickly (represents semi-strong efficiency form)
- Investors can't outperform on the market often (represents strong efficiency form)
Evidence of Financial Market In-Efficiency
- January effectJanuary effectThe January effect is a calendar-related anomaly in the financial market where financial security prices increase in the month of January. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases.Therefore, the main...
(repeating and predictable price movements and patterns occur on the market)
- Stock market crashes, Asset Bubbles, and Credit Bubbles
- Investors that often outperform on the market such as Warren Buffet , institutional investors, and corporations trading in their own stock
- Certain consumer credit market prices don't adjust to legal changes that affect future losses
Market efficiency types
James TobinJames Tobin
James Tobin was an American economist who, in his lifetime, served on the Council of Economic Advisors and the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He developed the ideas of Keynesian economics, and advocated government intervention to...
identified four efficiency types that could be present in a financial market:
1. Information arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
efficiency
Asset prices fully reflect all of the privately available information (the least demanding requirement for efficient market, since arbitrage includes realizable, risk free transactions)
Arbitrage involves taking advantage of price similarities of financial instruments between 2 or more markets by trading to generate losses.
It involves only risk-free transactions and the information used for trading is obtained at no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that arbitrage is a result of market inefficiency.
This reflects the weak-information efficiency model.
2. Fundamental valuation efficiency
Asset prices reflect the expected past flows of payments associated with holding the assets (profit forecasts are correct, they attract investors)
Fundamental valuation involves lower risks and less profit opportunities. It refers to the accuracy of the predicted return on the investment.
Financial markets are characterized by predictability and inconsistent misalignments that force the prices to always deviate from their fundamental valuations.
This reflects the semi-strong information efficiency model.
3. Full insurance efficiency
It ensures the continuous delivery of goods and services in all contingencies.
4. Functional/Operational efficiency
The products and services available at the financial markets are provided for the least cost and are directly useful to the participants.
Every financial market will contain a unique mixture of the identified efficiency types.
Conclusion
Financial market efficiency is an important topic in the world of FinanceFinance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
. While most financiers believe the markets are neither 100% efficient, nor 100% inefficient, many disagree where on the efficiency line the world's markets fall.
It can be concluded that in reality a financial market can’t be considered to be extremely efficient, or completely inefficient.
The financial markets are a mixture of both, sometimes the market will provide fair returns on the investment for everyone, while at other times certain investors will generate above average returns on their investment.