Market efficiency refers to the ability of a market to quickly and accurately reflect all relevant information in the prices of assets. An efficient market is one where prices adjust rapidly to new information, ensuring that prices accurately represent the true value of the asset.
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In an efficient market, prices adjust rapidly to new information, ensuring that assets are accurately valued.
Market efficiency implies that it is impossible to consistently outperform the market through active trading strategies, as all relevant information is already reflected in prices.
The efficient market hypothesis (EMH) suggests that financial markets are efficient, meaning that asset prices fully reflect all available information.
The three forms of market efficiency are weak-form, semi-strong form, and strong-form, which differ in the amount of information reflected in prices.
Factors that contribute to market efficiency include low transaction costs, easy access to information, and a large number of well-informed and rational investors.
Review Questions
Explain how the market system acts as an efficient mechanism for information.
The market system is an efficient mechanism for information because prices quickly and accurately reflect all relevant information. In an efficient market, asset prices adjust rapidly to new information, ensuring that they represent the true value of the asset. This allows the market to allocate resources to their most valuable uses, as prices guide the decisions of buyers and sellers. The efficient incorporation of information into prices ensures that no investor can consistently earn above-average returns based on that information, as it is already reflected in the market.
Describe the different forms of market efficiency and how they relate to the amount of information reflected in asset prices.
The three forms of market efficiency are weak-form, semi-strong form, and strong-form. Weak-form efficiency means that prices reflect all information contained in the historical sequence of prices, implying that technical analysis cannot be used to earn above-average returns. Semi-strong form efficiency means that prices reflect all publicly available information, including historical prices and other data. Strong-form efficiency means that prices reflect all information, both public and private, and that no investor can consistently earn above-average returns, even with access to insider information.
Analyze how factors such as transaction costs, information access, and the number of investors contribute to the efficiency of a market.
Several factors contribute to the efficiency of a market. Low transaction costs, such as brokerage fees and taxes, allow investors to quickly buy and sell assets, facilitating the rapid incorporation of new information into prices. Easy access to information, through channels like financial news and research reports, ensures that all relevant data is widely available to investors. A large number of well-informed and rational investors, each acting independently, helps to ensure that all available information is quickly reflected in asset prices. These factors work together to create an efficient market where prices accurately represent the true value of assets.
Related terms
Informational Efficiency: The degree to which asset prices fully reflect all available information, meaning no investor can consistently earn above-average returns based on that information.
The ability of a market to allocate resources to their most valuable uses, ensuring that goods and services are produced and distributed in the most optimal way.