What is Meant by Market Effciency?

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Market efficiency has been a topic of interest and debate central amongst financial economists for more than five decades. Indeed, two of the recipients of the Nobel Memorial Prize in Economic Sciences in 2013, Eugene Fama and Robert Shiller, have debated about the efficiency of markets since the 1980s. Concerns about market efficiency were catapulted to prominence most recently by the financial crisis of 2007-8. Efficient capital markets are foundational to economic theories that posit the allocative efficiency of free markets, which requires informationally efficient capital allocation markets, such as those for equity and fixed income trading. An extended line of research has uncovered evidence of various anomalies which seem to challenge notions of market efficiency, and has also attempted to explain the causes of one such anomaly, the so-called “size effect.” Though there appears to be substantial evidence that the size effect is real and persistent, violating the efficiency market hypothesis, no substantial evidence supports the size effect as violating market efficiency.

Market Efficiency

Refers to the efficiency with which markets allocate savings amongst competing investments. “In an allocationally efficient market, scarce savings are optimally allocated to productive investments in a way that benefits everyone” (Copeland, et al., 2005, p. 353). To provide optimal investment allocation, capital prices must provide market participants with accurate signals, and therefore prices must fully and instantaneously reflect all available relevant information (Copeland, et al., 2005). In advanced economies, secondary stock markets play an indirect role in capital allocation by revealing investment opportunities and information about managers’ past investment decisions (Dow & Gorton, 1997). For secondary stock markets, and other formal capital markets, to efficiently and effectively fulfill these two roles, securities prices must “be good indicators of value” (Fama, 1976, p. 133). Therefore, allocative market efficiency requires capital market prices to be informational efficient. Informational efficiency implies no-arbitrage pricing of tradeable securities and entails several defining characteristics that form the basis of the efficiency market hypothesis. Generally, “A market is efficient with respect to information set Θ_t if it is impossible to make economic profits by trading on the basis of information set Θ_t” (Jensen, 1978, p. 98), where economic profits are defined as risk-adjusted returns minus trading and other costs. If security prices reflect all available relevant information, such as P/E ratios and past return variances, then it would be impossible to to use such information to profitably trade these securites. Therefore tests of the possibility of using publicly available information to earn economic profits constitute tests of infomational effiency. Tests of informational market efficiency generally take three forms, and comprise the elements of the efficient market hypothesis. Fama (1969) defined the three forms of market efficiency as the weak, semi-strong and strong form, with each form characterised by the nature of the information central to its application. Weak form efficiency tests are tests of the viability of using past price history of the market to predict future returns (which is a necessary, but not sufficient, condition for trading for economic profits).

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