Published On:Wednesday, 4 January 2012

Posted by Muhammad Atif Saeed

Financial market efficiency is one of the main terms used in financial markets. Financial market efficiency can neither be 100% efficient nor 100% inefficient. But, there are many theories and research done on market efficiency.

There is an old saying that a financial market is said to be efficient if the prices fully reflects the available information. In financial markets, efficiency refers to the efficiency of resource allocation. This is also called as allocation efficiency. An efficient financial market should produce right goods at the right place for the right people.

Eugene Fama, an American economist very well know for asset pricing and portfolio theory, identified three levels of market efficiency:

1. Weak form efficiency:
If the prices of the shares or securities reflect the history of its price, then this comes under weak form efficiency. These forms of market will have the opportunity to predict the future price values.

2. Semi strong:
In this form of market, only investors who have in-depth information of the market could earn more. All the publicly available information will reflect the share or security price.

3. Strong form:
Here, all of the public and in depth information have an impact on the asset price. This form of market will be completely unpredictable. There will be no information available for investors to research and invest on shares which produce better advantage. Because of this, no one can rule the market and the price prediction is extremely difficult.

Efficient Market Hypothesis also called as EMH, is a theory created by Fama which states that, the prices on the market reflects all known information and also varies quick to reflect new information. Luck can be the only tool which helps the investors. Every investor would have the same information available in their hand. So, no one can shine in the market.

James Tobin, another American economist who served for Council of Economic Advisers, declared four types of market efficiency:

1. Information arbitrage efficiency:
Here, prices reflect the public information available. Financial instruments can be used efficiently to generate profit. The information used for trading will be available at no cost. Investors have more opportunity to predict the market price. So, this type of efficiency is close to weak efficiency model.

2. Fundamental valuation efficiency:
In this type, future flow of payments has an effect on the market price. It has both high risk and high profit opportunities. If invested wisely, this type could return more profit. This type of market can be said as a semi-strong efficiency model.

3. Full insurance efficiency:
The flow of products and the services would be continuous

4. Functional or operational efficiency:
In this type of efficiency, the products and services will be available for a low price and the investors directly have an advantage over the price.