There are several concepts of efficiency for a financial market. The most widely discussed is informational or price efficiency, which is a measure of how quickly and completely the price of a single asset reflects available information about the asset’s value. Other concepts include functional/operational efficiency, which is inversely related to the costs that investors bear for making transactions, and allocative efficiency, which is a measure of how far a market channels funds from ultimate lenders to ultimate borrowers in such a way that the funds are used in the most productive manner.
- 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 profits.
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 semi-strong efficiency model.
- Fundamental valuation efficiency
Asset prices reflect the expected 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 weak information efficiency model.
- Full insurance efficiency
This ensures the continuous delivery of goods and services in all contingencies.
- 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.
Informational efficiency levels
In the 1970s Eugene Fama defined an efficient financial market as “one in which prices always fully reflect available information”.
Fama identified three levels of market efficiency:
- 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, i.e past data on stock prices is of no use in predicting future stock price changes.
- Semi-strong efficiency
Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have an advantage in the market. Any price anomalies are quickly found out and the stock market adjusts.
- Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no one can have an advantage in the market in predicting prices since there is no data that would provide any additional value to the investors.
Evidence of financial market efficiency
- Predicting future asset prices are 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 inefficiency
- There is a vast literature in academic finance dealing with the momentum effect that was identified by Jegadeesh and Titman. Stocks that have performed relatively well (poorly) over the past 3 to 12 months continue to do well (poorly) over the next 3 to 12 months. The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average returns. Being simply based on past stock returns that are functions of past prices (dividends can be ignored), the momentum effect produces strong evidence against weak-form market efficiency, and has been observed in the stock returns of most countries, in industry returns, and in national equity market indices. Moreover, FAMA has accepted that momentum is the premier anomaly.
- January effect (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 Buffett, institutional investors, and corporations trading in their own stock.
- Certain consumer credit market prices don’t adjust to legal changes that affect future losses.
Types of Capital market
According to the efficient market theory formulated by American economist Eugene Fama, there are three forms of efficiency:
This form of market efficiency theory suggests that current market prices of securities reflect their previous or historical prices. Thus, it means that market participants who are buying and selling securities by analysing their historical data should earn normal returns. Hence, any new price changes in future can only take place if new information becomes publicly available.
According to this theory, popular investing strategies like technical analysis or momentum trading will not be able to beat the market on a consistent basis. But, it proposes that there is room for earning excess returns by using fundamental analysis.
In a semi-strong variation of an efficient market, the current prices of securities represent all information that is publicly available. It includes historical information like price, volume and more. This form of theory assumes that securities make quick adjustments in response to any newly available information. Thus, traders won’t be able to outperform the market by trading on such information.
It dismisses both technical and fundamental analysis since any information gathered by using these techniques will already be available to other investors. Only private information that is unavailable in the market would be useful for an investor to have the edge over others.
This form of market efficiency theory states that market prices of securities reflect public and private information both. Consequently, investors will not be able to beat the market by trading on any private information since all such information will already be factored into the market prices of the securities.