The Principle of Capital Market Efficiency

The Principle of Capital Market Efficiency
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Efficiency of Capital Markets

News is happening all the time. In our modern society, information comes at us in a variety of forms such as newspapers, television, radio, and Internet sources. Capital markets are efficient in reflecting this information in the form of price changes of securities. When something happens that affects a particular security, you can be sure that price changes will occur quickly and efficiently.

Suppose that an investor has a significant amount of money invested in an automobile manufacturer. And suppose that news of a major steel industry strike is announced on a television news channel. Steel, being a major component of automobile manufacturing, may be in short supply until the strike is resolved. Consequently, automobile manufacturers may have to pay more money than usual for steel for an unforeseeable amount of time thereby making the company less profitable. It can be assured that soon after the announcement, prices of the company’s stock will go down as a result of the new information.

Capital markets are efficient; security prices reflect all information available regarding their profitability. The efficiency of a market is dictated by three major aspects. First, the size of the market determines the number of securities traded. The larger the market, the more efficiently information is reflected in prices.

Second, the number of participants increases the intensity of competition. Therefore, new information is used as quickly as possible to try to gain an advantage over investors unwilling or unable to make adjustments to their portfolios as a result of new information. The reality is that only a very few number of first responders really ever benefit from new information. Generally, you can assume that by the time you hear the new information, the prices have already changed.

Third, the easier it is to trade securities, the more efficient a market is. In most security exchange markets, trading is quite simple with relatively low costs in comparison to the purchase of real assets such as cars, computers, or real property. Low trading costs mean fewer road blocks to trading. This is what makes a market efficient.

Where price differences exist between markets, arbitrage is possible. Arbitrage is the simultaneous buying and selling of an asset for a riskless gain. Differences in market efficiencies between two markets make arbitrage possible. Suppose on the New York Stock Exchange a share of stock is selling for $100 and in the London Exchange it is selling for $110. This price differential temporarily allows an investor to buy the stock for $100 in one market and immediately sell it for $110 in another making a riskless profit of $10 per share. It is because of market inefficiencies that arbitrage is possible.

Although not perfectly efficient, new information is reflected in security price changes quickly. This is due to the competition among investors governed by the fact the investors act in their own financial self-interest. When new information is available, investors act quickly to make decisions to their advantage.

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This post is part of the series: Financial Transactions: Principles and Theory

In competitive capital markets, financial transactions have several attributes that every good investor knows. By understanding the topic of risk-return trade-off, diversification, capital market efficiency, and time value of money, the investor is better suited to complete.

  1. The Risk/Return Trade-Off Principle
  2. Offsetting Capital Market Risk through Diversification of Your Portfolio
  3. The Effects of Information on Capital Market Efficiency
  4. Financial Markets and the Principle of the Time Value of Money