Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 10 - The Efficiency of Financial Markets

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter ten.

Chapter Introduction

One of the largest areas of research and interest in finance concerns the efficiency of financial markets. There have been studies of the efficiency of bond markets, the foreign exchange market, the stockmarket and more recently of derivative markets such as the options and futures market. In this chapter we restrict ourselves to examining the efficiency of stockmarkets.

One could consider market efficiency from a variety of viewpoints. For instance, we could consider the allocative efficiency of capital markets; that is, how good are they at allocating scarce capital resources among competing uses? In an ideal world, capital would be allocated to the firms that can achieve the best marginal returns. Alternatively, we could consider the operational efficiency of the capital market. In an ideal world, the costs of raising capital would be minimized and viable long-term projects would be able to raise capital as easily as short-term ones. Furthermore, investors would be faced with minimal transaction costs, such as negligible bid–ask spreads on securities, and competition between brokers would ensure only normal profits in the securities industry.

While allocative and operational efficiency are clearly desirable, the finance literature has concentrated on another type of efficiency relating to the pricing of securities. According to this definition, financial markets are informationally efficient if the current market price of a security instantly and fully reflects all relevant available information. In this chapter we focus on various types of informational efficiency according to a classic classification suggested by Fama (1970) that distinguishes between weak-form efficiency, semi-strong-form efficiency and strongform efficiency. We also review some of the empirical investigations into the question of efficiency in relation to the pricing of shares.

The question of whether markets are informationally efficient is of more than academic interest. If they are, this can help to ensure that scarce capital is efficiently allocated amongst its alternative uses. Firms with the best prospective profitability profiles should see this reflected in rises in their share price, and should find that they can raise new capital more easily and at less cost than firms with poor profit potential. Furthermore, firms that fail to use their capital efficiently will find that their share price is depressed and they may well become takeover targets. This usually results in a new management team that hopes to use the capital base more productively. Hence, informational efficiency is not entirely divorced from the idea of allocative efficiency.

Learning Objectives

In this chapter you will learn about:
  • ​The difference between operational efficiency and market efficiency
  • The differences between weak, semi-strong and strong forms of market efficiency
  • The difference between passive and active fund management
  • The various types of tests that have been conducted to test for market efficiency
  • The behavioural finance challenge to market efficiency

Further Reading

Campbell, J.W., Lo, A.W. and MacKingley, A.C. (1997) The Econometrics of Financial Markets, Princeton University Press.

Fox, J. (2009) The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street, Harper Business.

Malkiel, B.G. (2004) A Random Walk Down Wall Street: The Time Tested Strategy for Successful Investing, W.W. Norton & Company.

Shiller, R.J. (2001) Irrational Exuberance, Princeton University Press.

Revision Questions

  1. Explain the difference between ‘weak form’, ‘semi-strong form’ and ‘strong form’ concepts of market efficiency.
  2. Would evidence that a fund manager whose portfolio has a beta of 1 has performed better than the stockmarket 8 years in a row be evidence against the semi-strong form concept of market efficiency? Explain your reasoning.
  3. New information hits a company share such that the share price rises from 100 pence to 120 pence and then the share price rises gradually over the following 6 months to 150 pence despite any further news. Is this evidence of market efficiency? Explain your reasoning.
  4. Briefly explain what is meant by the January effect and discuss its relevance to the weak form of market efficiency.
  5. The stock market falls by 33 per cent in one day: is this necessarily inconsistent with the efficient market hypothesis? Explain your reasoning.
  6. What is meant by behavioural finance? Give two examples of behavioural effects and their implications for market efficiency.

Multiple Choice Questions

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