Market efficiency is a relatively broad term and can refer to any metric that measures information dispersion in a market. An efficient market is one where all information is transmitted perfectly (everyone receives the information), completely (everyone receives the entire information), instantly (everyone receives the information at once), and for no cost (everyone receives the information for free).
The notion of market efficiency is closely tied to the Efficient Market Hypothesis, which was developed by Eugene Fama, an American financial economist. Fama built on the work done by other financial economists such as Harry Markowitz, Fischer Black, Myron Scholes, Jack Treynor, William Sharpe, Merton Miller, Franco Modigliani, John Lintner, Jan Mossin, and Robert Merton.
Market efficiency is a relatively broad term and can refer to any metric that measures information dispersion in a market. An efficient market is one where all information is transmitted perfectly, completely, instantly, and for no cost.
Asset prices in an efficient market fully reflect all information available to market participants. As a result, it is impossible to ex-ante make money by trading assets in an efficient market.
Market efficiency DOES NOT say that the price of an asset is its true price. It only says that it is impossible to consistently estimate whether the asset price will move up or down.
What is an Efficient Market?
An efficient market is characterized by a perfect, complete, costless, and instant transmission of information. Asset prices in an efficient market fully reflect all information available to market participants. As a result, it is impossible to ex-ante make money by trading assets in an efficient market.
The result provides an alternate definition of market efficiency, which is particularly popular among financial markets participants – An efficient market is any market where asset price movements can’t be consistently estimated, i.e., it is impossible for an investor to consistently make money in an efficient market by trading financial assets.
Implications of Market Efficiency – An Illustrative Example
Company ABC is a publicly-traded technology company listed on the New York Stock Exchange (NYSE). The company releases a new product that is more advanced than anything on the market. If all the markets that Company ABC operates in are efficient, then the release of the new product should not affect the company’s share price.
Company ABC hires workers from an efficient labor market. All workers are, therefore, paid the exact amount that they contribute to the company.
Company ABC rents capital from an efficient capital market. Therefore, the rental paid to capital owners is exactly equal to the amount contributed by capital to the company.
If the New York Stock Exchange is an efficient market, then Company ABC’s share price perfectly reflects all information about the company. Therefore, all participants on the NYSE could predict that Company ABC would release the new product. As a result, the company’s share price does not change.
Market Efficiency – What It Does Not Imply?
1. Asset prices never deviate from their true price
The above statement represents a fundamental misunderstanding of the notion of market efficiency. Market efficiency DOES NOT say that the price of an asset is its true price. It only says that it is impossible to consistently estimate whether the asset price will move up or down.
2. All market participants are perfectly rational
Perfectly rational market participants is not a necessary condition for an efficient market. If market participants demonstrate independent and uncorrelated deviations from rationality, then an efficient market can be achieved.
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