Market Efficiency

Definition

Market efficiency refers to the degree to which asset prices fully reflect all available information. In an efficient market, prices adjust rapidly to new information, and it is not possible to consistently achieve returns in excess of average market returns on a risk-adjusted basis.

5 Must Know Facts For Your Next Test

1. In an efficient market, asset prices adjust rapidly to new information, reflecting the true value of the asset.
2. The efficient market hypothesis (EMH) states that it is impossible to consistently achieve returns in excess of the market average on a risk-adjusted basis.
3. Information asymmetry, where one party has more or superior information than another, can lead to market inefficiencies and the potential for abnormal returns.
4. Households supply financial capital to the market through investments, savings, and other financial instruments, contributing to market efficiency.
5. Market efficiency is a key concept in financial markets, as it affects the ability of investors to make informed decisions and achieve desired returns.

Review Questions

• Explain how the concept of market efficiency relates to the demand and supply of financial assets in the market.
  • In an efficient market, the demand and supply of financial assets, such as stocks, bonds, and derivatives, are expected to quickly adjust to new information, ensuring that asset prices reflect their true value. This means that investors cannot consistently achieve returns in excess of the market average by exploiting information asymmetries or other market inefficiencies. The rapid adjustment of prices to new information is a key characteristic of an efficient market, as it ensures that the demand and supply of financial assets are in equilibrium.
• Describe how the problem of imperfect information and information asymmetry can impact market efficiency.
  • The presence of imperfect information and information asymmetry can lead to market inefficiencies. When one party in a transaction has more or superior information compared to another, it can create an imbalance of power and the potential for abnormal returns. This information asymmetry can prevent asset prices from fully reflecting all available information, as some investors may have an advantage in accessing or interpreting relevant data. As a result, market efficiency is reduced, and the ability of investors to make informed decisions and achieve desired returns may be compromised.
• Analyze the role of households in supplying financial capital and how this contributes to market efficiency.
  • Households play a crucial role in supplying financial capital to the market through various investment vehicles, such as savings accounts, retirement funds, and direct investments in financial assets. The collective actions of households in allocating their financial resources contribute to the overall efficiency of the market. When households make informed decisions about how to deploy their financial capital, they help ensure that assets are priced appropriately and that the market functions efficiently. This, in turn, allows for the efficient allocation of resources and the ability of investors to achieve desired returns. The participation of households in the financial markets is a key component of market efficiency.

Related terms

Efficient Market Hypothesis (EMH): The theory that asset prices fully reflect all available information, making it impossible for investors to consistently achieve returns in excess of the market.

Information Asymmetry: A situation where one party in a transaction has more or superior information compared to another, leading to an imbalance of power in the transaction.

Financial Capital: The monetary resources available to a business or individual that can be used to generate income or acquire assets.