Informational Efficiency

Definition

Informational efficiency refers to the degree to which asset prices fully reflect all available information relevant to their valuation. In an informationally efficient market, new information is quickly and accurately incorporated into prices, leaving no opportunities for investors to consistently earn abnormal returns through the use of that information.

5 Must Know Facts For Your Next Test

1. Informational efficiency is a key concept in the Efficient Market Hypothesis, which states that asset prices fully reflect all available information.
2. In an informationally efficient market, new information is quickly and accurately incorporated into asset prices, leaving no opportunities for investors to consistently earn abnormal returns.
3. The Random Walk Theory is closely related to the concept of informational efficiency, as it suggests that asset prices follow a random, unpredictable path that cannot be predicted based on past information.
4. Weak-form efficiency is a level of market efficiency where asset prices fully reflect all information contained in the history of past prices, making it impossible to consistently earn abnormal returns through technical analysis.
5. Informational efficiency is often measured by the speed and accuracy with which asset prices respond to new information, with more efficient markets exhibiting faster and more accurate price adjustments.

Review Questions

• Explain how the concept of informational efficiency is related to the Efficient Market Hypothesis.
  • The concept of informational efficiency is a central tenet of the Efficient Market Hypothesis (EMH). The EMH states that asset prices fully reflect all available information relevant to their valuation, and that it is impossible to consistently outperform the market by using superior information or analysis. Informational efficiency refers to the degree to which this is true, with more informationally efficient markets exhibiting faster and more accurate incorporation of new information into asset prices. The EMH and informational efficiency are closely linked, as the efficient incorporation of information into prices is a key requirement for the EMH to hold true.
• Describe the relationship between informational efficiency and the Random Walk Theory.
  • The concept of informational efficiency is closely related to the Random Walk Theory, which posits that asset prices follow a random, unpredictable path that cannot be predicted based on past information. In an informationally efficient market, new information is quickly and accurately incorporated into asset prices, leaving no opportunities for investors to consistently earn abnormal returns by using that information. This aligns with the Random Walk Theory, which suggests that future price movements cannot be predicted based on past price movements or any other available information. The informational efficiency of a market is a key factor in determining whether asset prices follow a random walk, as the more efficient the market, the more closely the price movements will adhere to a random, unpredictable pattern.
• Analyze how the different levels of market efficiency, such as weak-form efficiency, relate to the concept of informational efficiency.
  • The different levels of market efficiency, as defined by the Efficient Market Hypothesis, are closely tied to the concept of informational efficiency. Weak-form efficiency, for example, is a level of market efficiency where asset prices fully reflect all information contained in the history of past prices. This means that in a weak-form efficient market, investors cannot consistently earn abnormal returns by using technical analysis or other methods that rely solely on past price information. This level of informational efficiency is directly related to the concept of informational efficiency, as it suggests that the market is able to quickly and accurately incorporate all relevant historical price information into current asset prices. The other levels of market efficiency, such as semi-strong form and strong form, represent progressively higher degrees of informational efficiency, where asset prices reflect increasingly more comprehensive sets of information. Analyzing how these different levels of efficiency relate to informational efficiency is crucial for understanding the overall concept and its implications for investment strategies and market dynamics.

Related terms

Efficient Market Hypothesis (EMH): The Efficient Market Hypothesis is a theory that states that asset prices fully reflect all available information, and that it is impossible to consistently outperform the market through the use of superior information or analysis.

Random Walk Theory: The Random Walk Theory posits that asset prices follow a random, unpredictable path, and that future price movements cannot be predicted based on past price movements or any other available information.

Weak-Form Efficiency: Weak-form efficiency is a level of market efficiency where asset prices fully reflect all information contained in the history of past prices, and it is impossible to consistently earn abnormal returns by using technical analysis.