Lesson 2 of 7
A wind vane that moves with the slightest movement in breeze is a good representation of an efficient market. A market that quickly accepts and integrates any new information related to assets is called an informationally efficient market or efficient market. In an ideal efficient market the asset price will reflect all past and present information.
In the real world, markets lie somewhere between an efficient and inefficient market. There are several factors that affect the efficiency of a market. Market players like investment managers and analysts are always on the lookout for inefficiencies in the market because these present opportunities for profitable trading opportunities. An efficient market does not enable consistent, risk-adjusted returns and calls for a passive strategy. In a passive strategy a broad portfolio is held and has low transaction and information costs.
An inefficient market on the other hand requires an active strategy which will help in achieving superior risk adjusted returns. It is important therefore to recognize if a market is efficient or inefficient based on certain factors.
In an efficient market asset prices need to reflect information quickly. This is done through trades and the time frame for information assimilation in asset prices is done through this mechanism. The time required to execute these trades can therefore be used as a base value to understand how quickly the inefficiency is being exploited and therefore the time required for adjustment. This in turn helps assess the efficiency of the market. The shortest time taken to make a trade is the minimum time required to assimilate the information into an asset. Studies in the foreign exchange market and developed equity markets have pegged this time to be as low as a minute. If this time window allows several traders to make a profit with minimum risk the market is considered to be inefficient. Market efficiency therefore can be monitored and viewed over a period of time rather than just as a snapshot.
Another important criterion to assess efficient markets is to observe how the market reacts to unexpected or unanticipated information and how that is incorporated into asset prices. This is then reflected in the trades by analysts.
If they perceive that the risk to be now undertaken does not support the returns they will sell it or short it. Traders who believe otherwise will buy it. An efficient market will therefore see a revision of positions when new information is provided.
To understand this let us take the case of what happens when a bond issuer announces they are going to default on an upcoming interest payment. This is done just before the bond market opens. The media had been speculating this event. This was done based on the following events. Suppliers had been insisting on being paid on cash putting pressure on the company’s liquidity. The issuer was under severe financial duress and would not be in a position to make an upcoming interest payment. Finally despite not having options in the capital market, the issuer was seeking a working capital loan which would enable to meet operational expenses for nine months and make upcoming interest payments. Based on this information analysts opine that bond holders will recover $0.36 to $0.38 per dollar face value in the event of the issuer defaulting on the bond.
A highly efficient market would take cognizance and give priority to the information that the issuer had failed in its negotiations for a line of credit from the bank. Further since the issuer had made an announcement that it would be failing in meeting its upcoming interest payment it would get reflected in the first trade prices after the market opens on the announcement day.
We will delve into the factors that determine the degree of efficiency of markets in the next article.