- Slides: 7
MARKET EFFICIENCY The concept of Market Efficiency: Investors determine stock price on the basis of the expected cash flows to be received from a stock and the risk involved. Rational investors should use all information they have available or can reasonably obtain. This information sets consist of both known information and beliefs about the future (i. e. , information that can be reasonably be inferred). Regardless of its form, information is the key to determination of stock price and therefore is the central issue of the efficient markets concept.
Efficient Market: An efficient market is define an one in which the prices of all securities quickly and fully reflected all available information about the asset. This concept postulates that all investors will assimilate all relevant information into price in making their buy and sell decisions. Therefore, the current price of a stock reflects: 1. All known information, including: • past information, • current information as well as events that have been announced but are still forthcoming.
2. Information that can reasonably be inferred; for example, if many of the investors believe that the bank’s deposit interest rate will go down, prices will reflect this belief before the actual event occurs. To summarize, a market is efficient relative to any information set if investors are unable to earn abnormal profits by using that information set in their investing decisions.
FORMS OF MARKET EFFICIENCY In a perfectly efficient market, security prices always reflect immediately all available information, and investors are not able to use available information to earn abnormal returns, because it is already impounded in prices. In such a market every security’s price is equal to its intrinsic (investment) value, which reflects all information about that security’s prospects. If some type information are not fully reflected in price or lags exist in the impoundment of information into prices, the market is less than perfectly efficient. In fact, the market is not perfectly efficient, and it is certainly not perfectly inefficient, so it is a question of degree.
Exactly how efficient is the market? Efficient Market Hypothesis (EMH): Market efficiency concerned with the extent to which security prices quickly and fully reflect available information. Efficient market hypothesis is divided into three categories- 1. Weak Form: One of the most traditional types of information used to assessing security values is market data, which refers to all past price (and volume) information. In a weak form efficient market, security’s current prices are already reflected of the historical price and volume data and should be of no value in predicting future price changes.
2. Semi-strong Form: A more comprehensive level of market efficiency involves not only known and publicly available market data, but all publicly known and available data such as earnings, dividends, stock split announcements, new product developments, financing difficulties, and accounting changes. A market that quickly incorporated all such information into prices is said to show semi-strong form efficiency. Thus, a market can be said to be “efficient in the semi-strong sense” if current prices quickly reflect all available information.
3. Strong Form: The most stringent from of market efficiency is the strong from, which assert that stock prices fully reflect all information, public and non-public. If market is strong-form efficient no group of investors should be able to earn, over a reasonable period of time, abnormal rate of return by using information in a superior manner. A second aspect of the strong form has to do with private information- that is, information not publicly available because it is restricted to certain groups such as corporate insiders and specialist on the exchanges. At the extreme, the strong from holds that no one with private information can make money using this information.