LM03 Market Efficiency

Part 1

1.  Introduction

Market efficiency concerns the extent to which market prices incorporate available information. Investors are interested in market efficiency because if prices do not fully incorporate information, then opportunities exist to make abnormal profits. Governments and regulators are interested in market efficiency because market efficiency promotes economic growth.

2.  The Concept of Market Efficiency

2.1.     The Description of Efficient Markets

• An informationally efficient market is one in which asset prices reflect new information quickly and rationally.
• ‘Quick’ is relative to the time a trader takes to execute an order. If it takes 15 minutes for new information to be incorporated into security prices and trade execution time is 30 minutes, we can say the new information is incorporated quickly.
• Market prices should not react to information that is well anticipated; only unexpected information should move prices.
• In a perfectly efficient market investors should use a passive investment strategy because active investment strategies will underperform due to transaction costs and management fees.

2.2.     Market Value versus Intrinsic Value

• Market value of an asset is its current price at which the asset can be bought or sold.
• Intrinsic value is the value that would be placed on an asset by investors if they had full knowledge of the asset’s characteristics.
• In highly efficient markets, full information is available in the market and is reflected in asset prices. Therefore, market value = intrinsic value.
• However, if markets are not efficient, the two prices can diverge significantly.

3. Factors Affecting Market Efficiency Including Trading Costs

The following factors affect a market’s efficiency:

• Market Participants – More participants increase efficiency.
• Information availability and financial disclosure – More information increases efficiency.
• Limits to trading – Limitations on arbitrage and short selling decrease efficiency.

Transaction Costs and Information-Acquisition Costs

Two types of costs are incurred by traders when trading on market inefficiencies: transaction costs and information-acquisition costs. These costs should be considered when evaluating a market’s efficiency.

• Transaction costs – High costs decrease efficiency.
• Information-acquisition costs – High costs decrease efficiency.

4. Forms of Market Efficiency

The table below introduces three forms of market efficiency which are differentiated based on assumptions about the level of information in security prices.

Evidence that investors can consistently earn abnormal returns by trading on the basis of information would challenge the efficient market hypothesis.

4.1 Weak Form

In a weak-form efficient market:

• security prices fully reflect all past market data.
• non-market public and private information is not necessarily incorporated into the stock price.
• technical analysts cannot make abnormal returns on a consistent basis simply by analyzing historical market information.

Tests to check whether securities markets are weak-form efficient:

• Look at patterns of prices. Is there any serial correlation in security returns? If yes, the market is not weak-form efficient.
• Can trading rules or any technical analysis method involving historical data be used to make abnormal profits? If yes, then it contradicts weak-form efficiency.

4.2 Semi-strong Form

In a semi-strong-form efficient market:

• prices reflect all publicly known and available information. This includes financial data such as earnings and dividends, and trading data such as closing prices, volume, etc. Weak-form is a subset of semi-strong-form.
• prices adjust quickly and accurately to new public information.
• efforts to analyze publicly available information are futile.
• fundamental analysis will not lead to abnormal returns in the long run. Lots of fundamental analysts (active investors, portfolio managers) evaluating securities to buy/sell help the market in becoming semi-strong-form efficient.

Tests to check whether securities markets are semi-strong-form efficient:

• Researchers test for when markets are semi-strong-form efficient using event studies. Most research indicates that developed securities markets are semi-strong-form efficient while developing countries’ markets may not be semi-strong-form efficient.

4.3 Strong Form

In a strong-form efficient market:

• prices reflect all public and private information. It encompasses semi-strong and weak form.
• investors will not be able to earn abnormal profits by trading on private information.

Tests to check whether securities markets are strong-form efficient:

• Researchers test whether a market is strong-form efficient by testing whether investors can earn abnormal profits by trading on non-public information.
• Most research indicates that markets are not strong-form efficient as regulations prohibit the use of private information (or insider trading).

5. Implications of the Efficient Market Hypothesis

We can draw the following implications of efficient markets on developed markets:

The role of portfolio managers is not necessarily to beat the market, but to establish and manage portfolios consistent with their clients’ objectives and constraints.

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