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Financial Banking Lecture notes - The Efficiency of Financial Markets
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Financial Banking Lecture notes - The Efficiency of Financial Markets for economics and finance and accounting students
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The Efficiency of Financial MarketsDifferent Concepts of Market Efficiency
The efficiency of markets can be considered in different ways:
Allocative efficiency: which is the efficiency with which the capital markets allocate the scarce capital
funds to the most productive uses. In an ideal world, capital would be allocated to the firms that can
achieve the best marginal returns.
Operational efficiency: this is the cost efficiency of the financial markets and financial institutions
described in terms of charges to investors. Ideally, the costs of raising capital would be minimized
and viable long-term projects would be able to raise capital as easily as short-term ones. Investors
would face minimal transaction charges as financial institutions compete for their business.
Informational efficiency: this is the extent to which market prices of securities fully incorporate and
reflects all relevant available information and react to changes in information so that abnormal
returns cannot be made on a consistent basis.
An efficient market was first defined by Eugene Fama (1970) as one “in which prices always “fully
reflect” available information”. There are three levels of efficiency:
Weak-form efficiency: this is where the current prices of securities instantly and fully reflect all
information of the past history of securities prices. In this case it should not be possible to make
consistent excess returns on securities by looking at the past history of their price movements and
using this as a basis for future trading.
Semi-strong-form efficiency: where the current prices of securities instantly and fully reflect all
publicly available information (such as past history of security prices, earnings, details in company
reports, announcements made by the firm and information about the state of the economy).
Therefore it should not be possible to make consistent excess returns on securities by using
publically available information as a basis for future trading.
Strong-form efficiency: where the current prices of securities instantly and fully reflect all
information, both publicly available information and privately held information held by company
insiders. In this case, even traders, directors or analysts with access to privileged inside information
should not be able to make consistent excess returns on securities by using inside information as a
basis for future trading.
Efficiency Hypothesis
The efficient market hypothesis (EMH) is a theory that says security prices reflect all available
information thus making it difficult for investors to make abnormal returns. If EMH holds then the
expected rate of return one period ahead will be the same as the actual return today and the return
on a security i can be formalised by a random walk:
R¿+1=E R
( )+u
¿+
1
It
t +1
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