What is Market Efficiency?

Market efficiency refers to the market's ability to provide investors with all available information about investment options for buying and selling securities. Market efficiency reflects the true value of securities without undervaluing or overvaluing them. When the quality and quantity of information increase, the market becomes more efficient, allowing it to reduce arbitrage and obtain higher market returns from investment. In a well-functioning market, everyone receives all information completely and immediately at no cost. It opens up a plethora of opportunities for investors to access various investment options.

In market efficiency, the market price of a security does not have to be equal to the stock's valuation all of the time. Prices can be higher or lower than the actual value due to random deviations. Using the investment strategies, no investor can consistently find overpriced or underpriced stock prices.

Efficient market hypothesis

Market efficiency concepts are linked to the efficient market hypothesis. Stock prices, according to the efficient market hypothesis, reflect all data traded in the market. All stock prices are only traded at their true value in an efficient market hypothesis. The efficient market hypothesis theory holds that because all investors in financial markets have access to the same information, investors cannot outperform the market.

Features of market efficiency

• Stock prices in an efficient market will reflect all historical data, including price, volume, and other relevant information.
• While buying and selling securities in the financial markets, investors have the opportunity to profit more.
• All disclosed data increases an efficient market by decreasing other opportunities for earning more returns and makes arbitrage trading impossible.
• Market participants, according to market efficiency, are unable to predict the future price of securities on a consistent basis. Stock prices do not always have to reflect a stock's true value.

Degrees of market efficiency

Following are the three levels of market efficiency:

Weak market efficiency form

The previous stock prices are reflected in the market's current stock prices in the weak form. Investors who analyze past stock prices will earn normal returns when buying and selling stocks in this case. A stock's future price cannot be predicted by examining past prices. Using popular strategies such as technical and momentum trading will not help you achieve better results in the market on a consistent basis in order to earn an excess return because those strategies rely on past data to predict future prices. The stock's future price movement will be determined by disclosed information rather than price series analysis. In its most basic form, fundamental analysis can open up opportunities for trading profits.

Semi-strong market efficiency form

When the stock price rapidly reflects on publicly available market data, the semi-strong form appears. Historical information such as volume, price, financial statements, news reports, and other data are also included in the data. Stock prices in semi-strong markets are quickly adjusted in response to market information. Using such information to trade in the market will not result in higher returns for investors. The price changes even when private information is made public. In order to trade in the stock market, investors rely on previously disclosed and publicly available information.

Strong market efficiency form

The stock price, in its most powerful form, reflects on public, private, and insider information. Investors will not be able to consistently predict the market for valuing stock prices in this case. Every piece of information has an effect on the stock's current price. Even leaked information from a company can have an impact on the stock price. Investors may or may not receive returns from investments in markets with high market efficiency.

Conditions for market efficiency

A market cannot be automatically efficient. It needs the actions of investors and analysts who create a scheme for profitability and bargain sensing. The conditions are as follows:

• The market must be large and liquid at the same time.
• All market-related data must be provided.
• A basic scheme for beating the market and earning excess returns should be provided in an efficient market.
• Securities that promote inefficiency should not be traded.
• The scheme's transaction costs should be less than the scheme's expected profits.
• To take advantage of the opportunities on market inefficiencies, investors must have sufficient funds to last until the exit.

Factors affecting market efficiency

Some of the factors that influence market efficiency are as follows:

Availability of information

The market will become more efficient as investors gain access to more information. Large and developed markets, such as the New York Stock Exchange, have a plethora of data, resulting in a relatively efficient market. In contrast, there will be a lack of information in emerging markets, and market prices will be less efficient. Assets traded on the over-the-counter market, in particular, have scant information. Without favoring one group over another, information should be easily accessible. Traders who have inside information about a company should be prohibited from trading in the market.

Trading impediments

Arbitrage is the simultaneous purchase and sale of an asset from one market to another at a higher price. This action will be repeated until the price of a specific stock in both markets is equal. Arbitrage can be hampered by high transaction costs and a lack of data, resulting in stock mispricing. Short-selling restrictions, such as the inability to borrow stock at a low cost, can reduce market efficiency.

Cost of transaction and information

When the cost of information, analysis, and trading exceeds the profit on traded stocks and the market price, the market is inefficient. A market will become efficient after the cost is reduced, and risk-adjusted returns cannot be obtained by trading on the basis of publicly available information.

Context and Applications

This article is significant in professional exams for bachelors of finance, bachelors of professional accountancy, bachelors of business analytics, bachelors of international marketing, masters of finance, masters of professional accountancy, masters in business analytics, masters in international marketing, master of science in finance, master of science in financial management, and master of business administration.

Practice Problems

Question 1: __________ refers to the market's ability to provide all available data to investors for trading.

1) Financial markets

2) Market efficiency

3) Market prices

Answer: Option 2 is correct

Explanation: Market efficiency refers to the market's ability to provide all possible information about investment options for investors in order for them to buy and sell securities.

Question 2:  _______ are reflected in a stock price in the efficient market.

1) Market prices

2) Intrinsic prices

3) Historical data, prices, and other information

Answer: Option 3 is correct

Explanation: In an efficient market, stock prices will reflect all historical data such as price, volume, and other relevant information.

Question 3: The past price of the stock has its effect on the current price of the stock in _______ form.

1) Weak-form

2) Strong form

3) Semi-strong form

Answer: Option 1 is correct

Explanation: In weak form, the previous stock prices are reflected in the present stock prices in the market. Here the investors who analyze the past stock prices will earn normal returns while buying and selling the stocks.

Question 4: In_______ stock prices are adjusted quickly in response to any information that is revealed in the market.

1) Weak-form

2) Strong form

3) Semi-strong

Answer: Option 3 is correct

Explanation: The semi-strong form appears when the stock prices reflect on the data that is available publicly in the market which also includes historical information like volume, price, financial statements, news reports, and other data in financial markets. The price of the stock adjusts quickly to available information that is disclosed.

Question 5: In strong form, the stock price reflects on ___________ information.

1) Political

2) Public, private, and insider

3) Efficient market hypothesis

Answer: Option 2 is correct

Explanation: In strong form, the stock price reflects on public, private, and insider information.  Here investors will not be able to predict the market consistently for valuing the stock prices.  Even minute information creates an impact on the current price of the stocks.