Week 3 Project

Market Efficiency

Market ef�ciency is an important concept in �nance. It addresses the necessity for new, pertinent information to be incorporated or responded to quickly by the markets.

Generally speaking, markets are said to be ef�cient when:

1. Prices adjust quickly in response to new information.

2. There is a continuous market where each successive trade is consummated at a price that is very close to the previous price.

3. The market can absorb a large capital in�ux without having large swings in stock prices.

4. Insider information is not relevant, or has no impact in the market.

As prices respond faster to new information, the market becomes more ef�cient. One key factor affecting ef�ciency is the uncertainty of cash �ow streams. However, cash �ow streams are more stable than volatile price changes.

Conversely, when cash �ow streams are more stable, fewer volatile price changes will occur. U.S. government securities are said to be the most ef�cient market. Moreover, the ef�ciency of common stock markets is still being debated.

The ef�cient market hypothesis (EMH) suggests that markets adjust rapidly and completely to new information, and it is very dif�cult for investors to create or select portfolios of securities which will outperform the market over a period of time.

The EMH assumes buyers and sellers have accounted for all available information about a given stock. Thus, a stock's current market price re�ects its true market value. In its strongest form, the EMH claims investors' returns cannot exceed general market returns over a long-time horizon. Based upon this premise, it would be useless to search for undervalued and overvalued stocks.

Most investors subscribe to a more moderate form of the EMH. These investors believe that a stock's market value is based upon—at least to some extent—forces of supply and demand in the overall stock market and/or a �rm's earnings potential and quanti�able risk. Accordingly, most investors believe they can potentially increase their returns and outperform the general market (at least in some periods and over some time horizon).

Financial managers and investors should realize that there is a direct relationship between information on market participants and the ef�ciency of the market. Uncertainty in a market obscures the process of information interpretation and valuation of securities.