Week 7 - Market Efficiency

Market Efficiency (ACC1017 Introduction to Finance)

1. Concept of Market Efficiency

  • Definition:

    • An informationally efficient market is one where asset prices quickly and rationally reflect new information.

    • Efficient markets incorporate all past and present information into asset prices.

  • Timing of Price Adjustment to New Information:

    • If price adjustments occur swiftly, allowing many traders to profit with little risk, the market is deemed relatively inefficient.

    • In an efficient market, price changes should respond primarily to unexpected information.

2. Market Value versus Intrinsic Value

  • Definitions:

    • Market Value:

      • The current price at which an asset can be bought or sold.

    • Intrinsic Value:

      • The value that investors assign to an asset based on its characteristics, assuming full understanding.

  • Investor Perspectives:

    • In a highly efficient market, investors generally accept market prices as reflective of intrinsic values.

    • In relatively inefficient markets, investors are inclined to formulate their own intrinsic value estimates.

3. Factors Affecting Market Efficiency

  • Key Factors:

    • Number of Market Participants:

      • A higher number typically enhances efficiency.

    • Information Availability and Financial Disclosure:

      • More information leads to more informed trading.

    • Limits to Trading:

      • Restrictions can hinder market efficiency.

    • Arbitrage:

      • The practice of capitalising on price differences to restore balance and efficiency.

    • Short-Selling:

      • It can expose inefficiencies in the market.

    • Transaction Costs and Information-Acquisition Costs:

      • High costs can limit the number of trades, impacting efficiency.

4. Forms of Market Efficiency

  • Weak-Form:

    • Prices reflect all past market data (historical prices and trading volumes).

    • Characteristics:

      • Presence of Serial Correlation.

      • Profitability of Technical Analysis is limited.

  • Semi-Strong Form:

    • Prices include all publicly known information, such as earnings, dividends, and market data.

    • Analysed through Event Studies on corporate actions like splits or announcements.

  • Strong Form:

    • Prices encompass both public and private information.

    • Includes insights into Insider Trading.