Market Efficiency and Its Three Forms

In this video we will take a look at the concept of market efficiency and the three forms of market efficiency.

Market efficiency is a very important concept for a portfolio manager. Market efficiency, a concept derived from the Efficient Market Hypothesis, suggests that the price of a security reflects all the information available about that security. So, in an efficient market, no investor has access to any special information that he can use to make an extra profit. In effect, if the markets are efficient, then you can’t beat the market.

The efficient market hypothesis (EMH) was formulated by Eugene Fama in 1970.

If the markets are perfectly efficient, then it does not make sense for the portfolio managers to pursue active investment strategies. The active investment strategies will actually underperform compared to passive strategies because of the additional transaction costs and fees.

So, are our markets really efficient and how do we measure the level of efficiency? One way to do so is to determine the time it takes for a trading activity to affect the price of the security, i.e., the time the information is made available and then time when the security’s price actually reflects it. In foreign exchange market, which is considered very efficient, this time lag may be less than a minute. If the time lag is high, then a trader who has this information will have sufficient time to use this information to make a profit.

Another important point is that if markets are efficient, the security’s price should not be affected by any information that was well anticipated by the investors. Only information that was not fully anticipated by the investors will have an impact on the price.

In a highly efficient market, the investors can expect the security’s market value to reflect its intrinsic value. In inefficient markets the securities can be overvalued or undervalued, that is their fundamental values can be above or below the prices at which they are trading. The traders can buy undervalued stocks and sell overvalued stocks to make a profit.

In reality the markets are not efficient. We can also not say that they are totally inefficient. Depending on a combination of factors markets exhibit varying degrees of efficiency. One such factor is the number of market participants. The more the number of participants such as investors, traders, and other participants, the more efficient is the market. This is simply because the more the number of participants actively involved in the market, the faster any price anomalies will be identified and the faster they will disappear.

The second factor affecting market efficiency is the availability of information. A higher availability of information will lead to higher market efficiency. For example, the information is more easily available in larger exchanges such as NYSE, that makes them more efficient compared to smaller exchanges where the information may not be disseminated that easily. The type of transactions also affect the market efficiency. For example, in over-the-counter markets, the information will not be available easily which makes them inefficient. The information should also be equally available to everyone. That’s why companies are required to disclose the same information to everyone.

Some markets may place restrictions on activities that impede market efficiency. Arbitrage is one such activity. Arbitrage involves taking advantage of price differences between markets. An arbitrageur will buy a security in a market where the price is low and sell it in the market where the price is high and make a risk-free profit. Arbitraging helps in price discovery and makes the markets more efficient. Some markets restrict short sale, which restricts arbitrage trading, which affects market efficiency.

The last factor affecting market efficiency is the transaction costs and other costs associated with trading and analysis. As long as these costs are high, the markets will be inefficient,

Based on the degree of information available, there are three forms of market efficiency. The weak- form of market efficiency states that the current stock prices fully reflect all the past market data. So, the past trading data is fully reflected in the stock prices and the trader cannot forecast the future stock prices based on the past stock prices.

The semi-strong form of market efficiency states that the current stock prices reflect all publicly available information including the past information. The Semi-strong form encompasses the weak-form.

The strong form of market efficiency states that the stock prices incorporate all the information available about the stock including the public and private information. So, if a market is strong form efficient, then even the traders with insider information cannot take advantage of their information to make abnormal profits.

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