Market efficiency is the extent to which stock prices indicate the available, relevant information. Market efficiency refers to informationally efficient capital markets that are all relevant information is incorporated into security prices, and then the market is informationally effective.
Some of the implications of the market being efficient are in perfectly efficient markets; the market value is an equal intrinsic value (fundamental value determined a security should have). It is recommended to use passive investment strategy (not active). Where we simply buy stocks if we want to invest in stocks with not must research over it. Whereas in active strategy some aggressive research as to if the stocks are undervalued. If markets are efficient then stocks will not be undervalued and hence, the cost of all this research is a waste.
And finally, in an efficient market only, unexpected information impacts the security’s price.
Measure of efficiency:
The Time lag from information dissemination to change in security prices.
- Example: Suppose a company X announces that it will have an increase in the price of its products and this has an immediate effect on the security’s price then we say that the market is efficient.
Factors affecting Market’s Efficiency:
How many market participants are included?
The number of participants, more efficient is the market.
- The idea behind this is that there are several market participants carefully evaluating the securities. So any smallest change in information will affect the buying selling activities rapidly, also adjusting the price of securities.
- If the information is easily available in abundant then the efficiency is going to be high.
- If there are higher limits of trading, then the efficiency is low. This means that if the operational efficiency is low and the market efficiency will also be less.
- When short selling (borrows and sells when the trader feels that the price is too high) is limited, then chances are that the prices might be little higher than they should be because if people are not allowed to short sell it makes it difficult for the prices to come down.
- If transaction costs are high then the market efficiency is low. If it costs a lot to buy a security that is underpriced, the trader will definitely consider those costs during buying decisions. This will make a security remain underpriced because it is simply too expensive to buy it.
- If the cost of getting any information is too low, then the market efficiency will be too low.
Efficient Market Hypothesis:
The efficient market hypothesis establishes a relationship between information and share prices in the capital markets of any economy.
Three forms of efficient Market Hypothesis.
- Weak form:
This is the most basic form. The Market is said to be a weak form efficient if all security market data are incorporated into security prices. This means that all data related to market prices of stock, volume, etc are incorporated into the prices. So security market data are included but all public and private information is not necessarily incorporated into security prices. The Implication is that we cannot use technical analysis to earn abnormal profits. We can test weak form using past data and use several technical analysis techniques and see whether those techniques would have given us abnormal returns.
- Semi-strong form:
All security market data and public data are incorporated into security prices. The Implication is that fundamental analysis cannot be used to earn abnormal returns. The Test can be done by several studies such as event study (reaction to stock prices based on events).
- Strong form:
All security market information, public information and private information is incorporated into security prices. Not even insiders and market makers can make abnormal profits. The Test can be made by analyzing whether market makers and insiders can make abnormal profits. The Strong form does not usually exist because there is sufficient evidence that market makers and insiders can make an abnormal profit.
- Technical Analysis: Analyzing stocks based on market data
- Fundamental Analysis: Analyzing stocks using economic fundamentals of the company and the economy, then come up with an appropriate price.
- Abnormal profits: excess returns over what you may expect.
- Security market information: current and past prices of securities, volumes etc.
- Market maker: security dealer who agrees to buy or sell at a certain price.
- Insider: Employee or staff belonging to a particular group who can avail information unavailable to others.