key term - Market Efficiency

Definition

Market efficiency refers to the extent to which stock prices reflect all available information at any given time. In an efficient market, securities are priced accurately, making it difficult for investors to achieve returns greater than average through expert stock selection or market timing, as all known information is already incorporated into the stock prices.

5 Must Know Facts For Your Next Test

1. Market efficiency can be categorized into three forms: weak, semi-strong, and strong, based on the type of information reflected in stock prices.
2. In a weak-form efficient market, past price movements and trends do not provide any predictive power for future price movements.
3. In a semi-strong efficient market, all publicly available information is reflected in stock prices, making it impossible for investors to gain an advantage through fundamental analysis.
4. A strong-form efficient market includes all information, both public and private; however, such markets are rarely observed in practice due to insider trading.
5. Market efficiency plays a crucial role in determining the legality of insider trading as it challenges the fairness of markets when privileged information is exploited.

Review Questions

• How does the Efficient Market Hypothesis relate to the concept of market efficiency?
  • The Efficient Market Hypothesis (EMH) is fundamentally linked to market efficiency because it posits that all available information is already factored into stock prices. This means that in an efficient market, no investor can consistently achieve returns above the market average without taking on additional risk. The EMH suggests that since information is quickly and accurately integrated into prices, any attempts at beating the market would be futile.
• Discuss the implications of insider trading on market efficiency and investor confidence.
  • Insider trading negatively impacts market efficiency because it creates an uneven playing field where some investors have access to confidential information that others do not. This exploitation of inside knowledge undermines investor confidence as it suggests that not all information is reflected in stock prices. When trust in the fairness of the market declines, it can lead to reduced participation from investors, ultimately harming overall market function.
• Evaluate how arbitrage contributes to enhancing market efficiency and its limitations in real-world applications.
  • Arbitrage enhances market efficiency by ensuring that price discrepancies between different markets are corrected quickly. When traders buy low in one market and sell high in another, they help align prices, reflecting true value based on available information. However, limitations exist due to transaction costs, taxes, and barriers such as regulations or liquidity issues that can hinder arbitrage opportunities. As a result, while arbitrage contributes significantly to market efficiency, it is not foolproof and may not always operate seamlessly.

Related terms

Efficient Market Hypothesis: A theory that asserts that financial markets are 'informationally efficient,' meaning that prices of securities reflect all available information, thus making it impossible to consistently outperform the market.

Insider Trading: The illegal practice of trading on the stock exchange to one's own advantage through having access to confidential information, which undermines market efficiency by creating unequal access to information.

Arbitrage: The simultaneous purchase and sale of an asset in different markets to profit from price discrepancies, which can help improve market efficiency by aligning prices across markets.