In the previous note on the lecture series of financial institutions and markets, we learned about the financial system, broadly classified into the financial markets and financial institutions. We have also seen how the supply and demand of funds affect the financial market and why financial market equilibrium is required. In this note, we will learn more about the efficiency of the financial market.
Financial Market Efficience
An efficient financial market provides fair pricing to both sellers and buyers. One of the critical characteristics of the financial market is that no one should be able to manipulate the market in their favor irrespective of whatever strategies one can apply. These are the few properties are highlighted as follows:
Resource Maximization
The ultimate focus of the efficiency in financial markets is on the non-wastefulness of factor use and the allocation of factors to the most socially productive purposes. In simple words, it states as follows:
- There is always a scarcity of resources, so whatever resources we have should be utilized to maximize the revenue out of this.
- And whatever revenue we are maximizing, it should have some social implications.
- It means the product should be used so that the maximum welfare can be generated.
- If we can maximize welfare, we can say that the system uses these scarce resources efficiently. However, if we cannot maximize the resources, we can say that the particular system is inefficient.
Fair Pricing
The market in which the price for any security effectively represents the expected net present value of all future profits.
- A market is where we pay the price and get the product. The price should reflect all available adequate cash flows that we are getting from that particular asset. If that happens, we can say the market is fundamentally efficient.
Equal and Fair Returns
Buying or selling of the security should, on average, return us only a fair measure of return for the associated risk.
- It means anybody or all the participants investing in the market on average should get some return; that does not mean that some investors will get very high returns and others do not or make losses in the market.
- As whatever informations are available about the market is open to everybody thus, we expect that a fair amount of return can be realized by all the market participants in this particular system.
Conditions for efficient Market
- A large number of competing profit-maximizing partidipants analyze and value securities, each independently of the others.
- Active participant in the market.
- Individuals can not affect the market prices.
- Informtion must be free.
- Free entry and exit by market players must be uninhibited.
Types of Efficiency
The market efficiency can be defined in five ways which James Tobin specified. He is a Nobel Laureate who has given the concept of market efficiency. It is defined as follows:
Information Arbitrage Efficiency
It is the degree of gain possible by using commonly available information. If one can make significant gains by using widely known information, financial markets are said to be inefficient. It means that if the information’s availability is equal to all the market participants, then one group of individuals or one group of investors cannot get more return.
Fundamental Valuation Efficiency
When the market price of a security is equal to its intrinsic value or investment value, the market is said to be efficient. The intrinsic value of an asset is the present value of the future stream of cash flows associated with the investment in that asset when the cash flows are discounted at an appropriate rate of discount. When the intrinsic value is equal to the market value, we can say that the market is fundamentally efficient.
Full Insurance Efficiency
It indicates the extent of hedging against possible future contingencies. The greater the possibilities of hedging and reducing risk, the higher is the market efficiency. Whenever we take a position in the financial market, we are exposed to certain risks, which means there is a chance of loss. If our investment is insured or protected to a certain extent, we can say that the market is efficient.
Functional or Operational Efficiency
The market must keep minimum administrative and transactions costs charged from borrowers and lenders. It means transaction costs should be minimal. For example, whenever we buy or sell shares in the stock exchange, they charge a certain amount as a commission.
Allocational Efficiency
When financial markets channelize resources into those investment projects and other uses where marginal efficiency of capital adjusted for risk differences is the highest. The marginal efficiency of capital is that whenever we produce any product and add one extra unit of capital to the production, that is called Marginal Efficiency of Capital (MEC). Then how will this additional unit of production increase the amount of production or investment vs. extra return?
Issues in Efficient Market
How well do markets respond to new information?
- For example, let us consider that the Reserve Bank of India (RBI) governor has announced repo rate, any policy measures taken by the finance ministry, or any crisis in the US market, as financial markets are highly integrated with the global market. So anything that happened in the worldwide community, any particular information that comes to the market, how well the market is well equipped to respond to that information.
- Whether the market is so mature, or it is so conducive to capture that information positively or larger, or there is some kind of loophole or some kind of gaps exists in the market to capture that information which is if it is negative information, the market perceive it negatively, if it is positive information, market perceives it positively.
- This information may create disturbance in the market and become volatile. Still, we should ensure that those things should not be there in the system, and that kind of thing should not change the price away from the equilibrium price.
- The system should ensure that it is so efficient that any news is coming to the market that particular news should be reflected in the price immediately. The market should be efficient enough to capture that information efficiently.
Should it be possible to decide between a profitable and unprofitable investment given the current information?
- For example, there should not be any gap between the different stakeholders to ensure which one is good for them and which one is bad. The investment they should make to maximize the return, which they should not make. So those kinds of things are significant whenever we talk about the efficiency of the market.
Efficient Market Hypothesis (EMH)
Over the period, we see that the information arbitrary efficiency has gained maximum attention. Therefore, the literature on the efficient market is mostly concentrated on the issues related to the information.
How far the market is efficient from the information point of view. Whether the market is efficient or there is an information gap between the different market participants, if yes, then what level of information gap they have and how the investors or market participants in the market will use that information for their investment activities.
In this context, the hypothesis was created, called the Efficient Market Hypothesis. It was proposed by Eugene Fama somewhere in 1962, and it became quite popular after that, even a lot of research work has been carried out in this area. The high-level gist of EMH is mentioned below.
- The current prices of securities reflect all information about the security (Random Walk Hypothesis). In simple words, whenever we see the price of a particular stock or bond (security), we should ensure that the specific price reflects or captures all available information about that specific stock. The stock price has been determined based on all the information which has come to the market.
- New information regarding securities comes to the market in a random fashion. If nobody knows what information will come in the next day, then the price will behave differently; however, if an individual or a group knows information a priorly, the price movement wouldn’t be fair. In simple words, knowing and unknowing knowledge give different returns to different participants, which creates inefficiency in the market. So if the new information comes to the market randomly in the true sense, then we say that market is efficient.
- Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information. The expected returns implicit in the current price of a security should reflect its risk. It means if further information comes, the demand and supply of that particular stock or asset will eventually change and regain the equilibrium price. Thus, market is so conducive to gather all this information, reflect in the prices as fast, and adjusted to the risk.
Now the question comes, to what extent do securities market quickly and fully reflect different available information? The efficient market hypothesis are categoried into three different forms and these are Weak form, Semi strong form and Strong form.
- Weak form: Prices reflect all security-market information
- Semi strong form: Prices reflect all public information
- Strong form: Prices reflect all public and private information
Weak Form EMH
The current security price reflects all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. It implies that past rates of return and other market data should not reveal a relationship with future rates of return.
The current price reflects the equilibrium price and is quickly adjusted by all the new information available in the market. Thus, seeing the historical data, nobody can predict the rates of return. However, the underlying assumption is that information is coming randomly and already captured through the current price of the particular security. Indian market is an example of weak efficient market.
Semi Strong Form EMH
The current security price reflects all public information such as earning, stock and cash dividends, splits, mergers and takeovers, interest rate changes, etc. It implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions. It also says that prices adjust to such information quickly and accurately. So, abnormal profits on a consistent basis can not be earned.
For example, suppose a company has announced the rate of dividend to be paid to the shareholders, the today’s return and on the ex-date (expiry of the last date to hold a stock to get dividend), would be the same. It means the price goes up on the announcement day and comes down on the ex-dividend day. So, on average, the return will be zero during this event period.
The above example shows that if all the information is available to everybody, the new event (random information) automatically adjusts the prices. It is not worth expecting high returns from an unexpected event. Thus, if all the information is coming publicly and everybody can use that, then there is no sense to expect very high returns from the market. US market is an example of semi strongly efficient.
Strong Form EMH
The current prices fully reflect all information from public and private sources. It implies that no group of investors should consistently derive above-average risk-adjusted rates of return. It assumes perfect markets in which all information is cost-free and available to everyone simultaneously. However, a perfect market assumption is not 100% possible.
For example, a company CEO must have more information about the latest updates about the company than the public or shareholders. Similarly, hedge fund managers, investors, regulators, etc., have more information than individual shareholders. If anybody has that extra information, those can make more returns than individual shareholders or retail investors.
Suppose we categorize people into two groups. The first group of people have private information, and the second group of people have only public information, then the returns between the two groups of people will be different. If this exists, then we can say that market is inefficient. On the other hand, if return differences are not there, the market is strongly efficient.
Note: No market is strongly efficient.
QnA
- Can we profit from the stock market while buying a stock before the dividend date and selling it on the ex-dividend date?
- Can I make more money if I have private information about the company before any event day?
- Can I maximize my returns from the stock market while accessing historical data about a stock?
References
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“Efficiency of financial market” From NotePub.io – Publish & Share Note! https://notepub.io/notes/finance/financial-institutions-and-markets/efficiency-of-financial-market/
