What is market efficiency?
Market efficiency is a relatively broad term and can refer to any metric that measures the dispersion of information in a market. An efficient market is one in which all information is transmitted perfectly (everyone receives the information), completely (everyone receives the information completely), instantly (everyone receives the information once), and free of charge (everyone receives the information for free).
The concept of market efficiency is closely related to the market efficiency hypothesis, developed by the American financial economist Eugene Fama. Fama drew on the work of other financial economists such as Harry Markowitz, Fisher Black, Myron Scholes, Jack Traynor, William Sharp, Merton Miller, Franco Modigliani, John Lintner, Jean Mossin and Robert Merton.
summary
Market efficiency is a relatively broad term and can refer to any metric that measures the dispersion of information in a market. An efficient market is one in which all information is transmitted perfectly, completely, instantly and at no cost.
Asset prices in an efficient market fully reflect all information available to market participants. As a result, it is impossible to make money in advance by trading assets in an efficient market.
Market efficiency does not say that the price of an asset is its true price. It just says that it is impossible to estimate whether the price of an asset will move up or down.
What is an effective market?
An efficient market is characterized by perfect, complete, cost-free and immediate information transmission. Asset prices in an efficient market fully reflect all information available to market participants. As a result, it is impossible to make money in advance by trading assets in an efficient market.
The result provides an alternative definition of market efficiency, which is especially popular among participants in financial markets – an efficient market is any market in which it is not possible to estimate the movements of asset prices statically, that is, it is impossible for an investor to constantly make money in an efficient market by trading financial assets.
Implications for Market Efficiency – Illustrative Example
ABC Corporation is a public technology company listed on the New York Stock Exchange (NYSE). The company is launching a new product that is more advanced than anything else on the market. If all of the markets in which ABC operates are efficient, the release of the new product should not affect the company’s stock price.
ABC Company recruits workers from an active labor market. Therefore, all workers pay the exact amount they contribute to the company.
Company ABC rents capital from the efficient capital market. Therefore, the rent paid to the owners of the capital is exactly equal to the amount contributed by the capital to the company.
If the New York Stock Exchange is an efficient market, then ABC Company’s stock price fully reflects all information about the company. Therefore, all participants in the New York Stock Exchange can expect ABC to launch the new product. As a result, the company’s share price does not change.
Market efficiency – what does it imply?
1. Asset prices never deviate from their true price
The above statement represents a fundamental misunderstanding of the concept of market efficiency. Market efficiency does not say that the price of an asset is its true price. It just says that it is impossible to estimate whether the price of an asset will move up or down.
2. All market participants are completely rational
Rational market participants are not a necessary condition for an effective market. If market participants show independent and unrelated deviations from rationality, then an efficient market can be achieved.