Level 1 CFA® Exam:
Market Efficiency
This lesson focuses on the concept of market efficiency. We're also going to discuss the intrinsic value and the market value and how they are related to market efficiency. Finally, we're going to talk about factors that affect efficiency.
We will begin by defining informationally efficient and inefficient markets.
Informationally efficient markets are markets with instruments whose prices reflect past and present information about their issuers. Because of that, in efficient markets it is not possible to make risk-adjusted returns higher than the market mean. And so investors select a passive investment strategy because it has lower transaction costs than active management.
The opposite type of market is an inefficient market where earning a risk-adjusted return higher than the market mean return is possible. As a result, active investing is more popular in such a market.
Both the market value and intrinsic value are fundamental terms in investing. Market value is a price at which transactions are actually conducted. Intrinsic value is the value of a financial instrument calculated given a complete set of data on its issuer and the instrument itself.
The relation between the market value and the intrinsic value is crucial. If the intrinsic value is higher than the market value, investors decide to buy an instrument. If it's the other way around, they choose to sell the instruments they hold.
It all sounds very simple, but in fact, it's more complicated. The market value is usually known to all investors, but the intrinsic value may only be estimated and nobody can be certain of their estimates. Note that if investors invest in efficient markets, they may assume that all the information about the issuer is priced and so the market value of an asset is similar to its intrinsic value.
If, however, they invest in inefficient markets, after estimating the intrinsic value they may take advantage of the difference between this value and the market value and then carry out the proper transaction.
Markets are neither entirely efficient nor inefficient. Now, we're going to discuss the factors which affect the level of this efficiency. These include:
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Every entity which trades in a market and gathers information bears costs. These include transaction costs and information-acquisition costs.
High transaction costs impede trading and lower market efficiency. It may happen that potentially profitable transactions become unprofitable after bearing their transaction costs. For example, in case of arbitrage, if transaction costs are higher than the difference between the prices of the same asset in two markets, arbitrage is unprofitable and will not occur.
Information-acquisition costs are costs borne when gathering and analyzing information. If we assume that the market is efficient, acquiring new information is pointless as the prices already include all available information, and given this, it is impossible to make abnormal returns from this additional information.
However, it is a kind of a paradox here: If a majority of investors gave up acquiring additional information, the market would no longer be efficient and the prices would not reflect all available information and it would be possible to make abnormal returns from new information.
As we mentioned before, an efficient market means that all information is incorporated in instruments’ prices. We also said that markets have different levels of efficiency. The most popular classification involving market efficiency was developed by Eugene Fama. It includes 3 forms of efficiency:
- weak form of market efficiency,
- semi-strong form of market efficiency, and
- strong form of market efficiency.
According to the weak form of market efficiency, all historical data are included in the prices of instruments. As a result, looking at historical patterns of prices and searching for correlations between the returns to predict price movements in the future is pointless because it will not allow us to make abnormal returns.
In the case of semi-strong efficiency, the prices reflect all publicly known and available information. That includes all data which are continuously provided by companies.
What does it mean that prices reflect information?
It means that the information is already considered by the investors in their decision-making as to whether to buy or sell and the analysis of such data won't generate any extra profit. You should remember that publicly known information also includes historical prices so if we deal with a market that is semi-strong efficient, it means it is also weak efficient.
Strong form of efficiency assumes that all information about companies, both public and private information, is immediately reflected in their prices. Naturally, it means that even insiders may not make abnormal returns.
Remember that a strong efficient market is at the same time weak and semi-strong efficient.
Finally, let’s discuss the consequences of the efficient market hypothesis for managers.
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- Informationally efficient markets are markets with instruments whose prices reflect past and present information about their issuers.
- In inefficient market earning a risk-adjusted return higher than the market mean return is possible.
- Market value is a price at which transactions are actually conducted.
- Intrinsic value is the value of a financial instrument calculated given a complete set of data on its issuer and the instrument itself.
- If the intrinsic value is higher than the market value, investors decide to buy an instrument.
- The higher the number of market participants, the more efficient the market is.
- There is a positive correlation between the availability of information and market efficiency.
- The tighter the trading limits, the lower the efficiency.
- High transaction costs impede trading and lower market efficiency.
- Information-acquisition costs are costs borne when gathering and analyzing information.
- According to the weak form of market efficiency, all historical data are included in the prices of instruments.
- In the case of semi-strong efficiency, the prices reflect all publicly known and available information.
- Strong form of efficiency assumes that all information about companies, both public and private information, is immediately reflected in their prices.
- The company’s earnings, sales, and cash flows forecasts are used for the fundamental analysis.
- A technical analyst studies changes in prices of financial instruments using only historical pricing and volume data.