Sunday, December 26, 2010

Financial Market Efficiency


In the 1970s Eugene Fama defined an efficient financial market as "one in which prices always fully reflect available information”.[1]
The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.
This includes producing the right goods for the right people at the right price.
A trait of allocatively efficient financial market is that it channels funds from the ultimate lenders to the ultimate borrowers in a way that the funds are used in the most socially useful manner.

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[edit]Market efficiency levels

Eugene Fama identified three levels of market efficiency:
1. Weak-form efficiency
Prices of the securities instantly and fully reflect all information of the past prices. This means future price movements cannot be predicted by using past prices.
2. Semi-strong efficiency
Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have advantage on the market.
3. Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no one can have advantage on the market in predicting prices since there is no data that would provide any additional value to the investors.

[edit]Efficient Market Hypothesis (EMH)

Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in any given time, the prices on the market already reflect all known information, and also change fast to reflect new information.
Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck.[2]

[edit]Random Walk theory

Another theory related to the efficient market hypothesis created by Louis Bachelier is the “random walk” theory, which states that the prices in the financial markets evolve randomly and are not connected, they are independent of each other.
Therefore, identifying trends or patterns of price changes in a market couldn’t be used to predict the future value of financial instruments.

[edit]Evidence

[edit]Evidence of Financial Market Efficiency
  • Predicting future asset prices is not always accurate (represents weak efficiency form)
  • Asset prices always reflect all new available information quickly (represents semi-strong efficiency form)
  • Investors can't outperform on the market often (represents strong efficiency form)
[edit]Evidence of Financial Market In-Efficiency
  • January effect (repeating and predictable price movements and patterns occur on the market)

[edit]Market efficiency types

James Tobin identified four efficiency types that could be present in a financial market:[4]
1. Information arbitrage efficiency
Asset prices fully reflect all of the privately available information (the least demanding requirement for efficient market, since arbitrage includes realizable, risk free transactions)
Arbitrage involves taking advantage of price similarities of financial instruments between 2 or more markets by trading to generate losses.
It involves only risk-free transactions and the information used for trading is obtained at no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that arbitrage is a result of market inefficiency.
This reflects the weak-information efficiency model.
2. Fundamental valuation efficiency
Asset prices reflect the expected past flows of payments associated with holding the assets (profit forecasts are correct, they attract investors)
Fundamental valuation involves lower risks and less profit opportunities. It refers to the accuracy of the predicted return on the investment.
Financial markets are characterized by predictability and inconsistant misalignments that force the prices to always deviate from their fundamental valuations.
This reflects the semi-strong information efficiency model.
3. Full insurance efficiency
It ensures the continuous delivery of goods and services in all contingencies.
4. Functional/Operational efficiency
The products and services available at the financial markets are provided for the least cost and are directly useful to the participants.
Every financial market will contain a unique mixture of the identified efficiency types.

[edit]Conclusion

Financial market efficiency is an important topic in the world of Finance. While most financiers believe the markets are neither 100% efficient, nor 100% inefficient, many disagree where on the efficiency line the world's markets fall.
It can be concluded that in reality a financial market can’t be considered to be extremely efficient, or completely inefficient.
The financial markets are a mixture of both, sometimes the market will provide fair returns on the investment for everyone, while at other times certain investors will generate above average returns on their investment.

[edit]References

  1. ^
    Vaughan Williams, Leighton (2005). Information efficiency in financial and betting markets. ISBN 0521816033.
  2. ^ Investopedia ULC (2009). "Efficient Market Hypothesis - EMH"
  3. ^ Reeves, John (May 2009). "Priceless Investment Advice" ([dead link]). MSNBC.
  4. ^ Market Efficiency: Stock Market Behaviour in Theory and Practice. Edward Elgar. 1997. ISBN 1858981611, 9781858981611.

[edit]Bibliography

  • Davidson, Paul. Financial markets, money and the real world. Edward Elgar Publishing, 2002.
  • Emilio Colombo, Luca Matteo Stanca. Financial Market Imperfections and Corporate Decisions. Springer, 2006.
  • Frisch, Ragnar Anton Kittel. Econometrica. Econometric Society, JSTOR, 1943.
  • Leffler, George Leland. The Stock Market. 2. Ronald Press Co., 1951.
  • Marc, Levinson. Guide to Financial Markets. 3. Bloomberg Press, 2003.
  • Peters, Edgar E. Fractal Market Analysis: Applying Chaos Theory to Investment and Economics. John Wiley and Sons, 1994.
  • Teall, John L. Financial market analytics. Greenwood Publishing Group, 1999.
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Economic efficiency


In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services.[1] Aneconomic system is said to be more efficient than another (in relative terms) if it can provide more goods and services for society without using more resources. In absolute terms, a situation can be called economically efficient if:
  • No one can be made better off without making someone else worse off.
  • No additional output can be obtained without increasing the amount of inputs.
  • Production proceeds at the lowest possible per-unit cost.
These definitions of efficiency are not exactly equivalent, but they are all encompassed by the idea that a system is efficient if nothing more can be achieved given the resources available.

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[edit]Theory

There are two main strains in economic thought on economic efficiency, which respectively emphasize the distortions created bygovernments (and reduced by decreasing government involvement) and the distortions created by markets (and reduced by increasinggovernment involvement). These are at times competing, at times complementary – either debating the overall level of government involvement, or the effects of specific government involvement. Broadly speaking, this dialog is referred to as Economic liberalism orneoliberalism, though these terms are also used more narrowly to refer to particular views, especially advocating laissez faire.
Further, there are differences in views on microeconomic versus macroeconomic efficiency, some advocating a greater role for government in one sphere or the other.

[edit]Mainstream views

The mainstream view is that market economies are generally believed to be more efficient than other known alternatives[2] and that government involvement is necessary at the macroeconomic level (via fiscal policy and monetary policy) to counteract the economic cycle – following Keynesian economics. At the microeconomic level there is debate about how to maximize efficiency, with some advocating laissez faire, to remove government distortions, while others advocate regulation, to reduce market failures and imperfections, particularly via internalizing externalities.
The first fundamental welfare theorem provides some basis for the belief in efficiency of market economies, as it states that any perfectly competitive market equilibrium is Pareto efficient. Strictly speaking, however, this result is only valid in the absence of market imperfections, which are significant in real markets. Furthermore, Pareto efficiency is a minimal notion of optimality and does not necessarily result in a socially desirable distribution of resources, as it makes no statement about equality or the overall well-being of a society.[3][4]

[edit]Schools of thought

Advocates of limited government, in the form laissez faire (little or no government role in the economy) follow from the 19th century philosophical tradition classical liberalism, and are particularly associated with the mainstream economic schools of classical economics(through the 1870s) and neoclassical economics (from the 1870s onwards), and with the heterodox Austrian school.
Advocates of an expanded government role follow instead in alternative streams of liberalism; in the Anglosphere (English-speaking countries, notably the United States, United Kingdom, Canada, Australia and New Zealand) this is associated with Institutional economics and, at the macroeconomic level, with Keynesian economics. In Germany the guiding philosophy is Ordoliberalism, in the Freiburg School of economics.

[edit]Microeconomic

Microeconomic reform are policies that aim to reduce economic distortions via deregulation, and increase economic efficiency. However, there is no clear theoretical basis for the belief that removing a market distortion will always increase economic efficiency. The Theory of the Second Best states that if there is some unavoidable market distortion in one sector, a move toward greater market perfection in another sector may actually decrease efficiency.

[edit]Criteria

There are several alternate criteria for economic efficiency, these include:
For applications of these principles see:

[edit]Competing goals

See also: Welfare economics
Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds. Most commonly, efficiency is contrasted or paired with morality, particularly liberty and justice. Some economic policies may be seen as increasing efficiency, but at the cost to liberty or justice, while others may be argued to both increase efficiency and be more free or just. There is debate on what effects specific policies have, which goals should be pursued, the relative weights that should be placed on different goals, and which trade-offs should be made.
For example, some advocates of laissez faire (such as classical liberalism in the 19th century and Objectivism in the 20th century) argue that such economies protect property rights and are thus both free and just, regardless of whether or not they are more efficient, though advocates also generally believe that laissez faire economies are more efficient.
Others argue that laissez faire leads to concentration of power and thus curtails liberty and reduces competition, and leads to unjust distribution of income and wealth, regardless of whether it increases efficiency, for example in the early 20th century American progressive movement – some (such as the Freiburg school) argue that laissez faire decreases efficiency in addition to being unfree and unjust, while others argue that government involvement may reduce efficiency, but that this is an acceptable cost for the increase in liberty and justice.
In welfare economics, trade-offs between efficiency and distributive justice, particularly in redistribution – to the extent that a certain policy decreases efficiency – is often visualized by the metaphor of the leaky bucket, imagining income or wealth as water moved between individuals, and inefficiency as leakage. Opponents of redistribution argue that redistribution is not only inefficient (the bucket leaks), but unjust (income or wealth should not be redistributed by the government at all, but rather the market alone should decide distribution).

[edit]References

  1. ^ Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 15. ISBN 0-13-063085-3.
  2. ^ Economics, fourth edition, Alain Anderton, p281
  3. ^ Barr, N. (2004). Economics of the welfare state. New York, Oxford University Press (USA).
  4. ^ Sen, A. (1993). Markets and freedom: Achievements and limitations of the market mechanism in promoting individual freedoms.Oxford Economic Papers, 45(4), 519-541.

[edit]See also

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