Sunday, February 10, 2008

The Role of Information in Stock and Capital Market Efficiency

Market efficiency is a concept describing market behavior. The assumption about market efficiency is a basic assumption in many economic and financial models and is required in order to build fundamentals.

At the basis of market efficiency are three assumptions:

1. There is a multitude of sellers and buyers with no one dominant enough to affect pricing.
2. There is homogeneity in products or services offered.
3. Perfect information is available to everyone.

These assumptions are required in order to demonstrate equilibrium of supply and demand which constitute the price and quantity of every product or service. These market dynamics also help in understanding the processes which takes place in inefficient markets.

Capital Market Efficiency

The capital market is often regarded as a market which is close to fulfilling the requirements of an efficient market where prices are determined by supply and demand as a result of the forces mentioned above.

It can be easily seen that the capital market does not completely satisfy the conditions set above but it can not be easily dismissed as well. Let's have a look at the relevance of the market efficiency assumption to the capital or stock market:

1. Multitude of sellers and buyers – It seems the existence of dominant players might not satisfy this condition for market efficiency. However there are some lenient circumstances. These players are regulated and monitored thus limiting their influence on stock prices. Also, if we look at the micro level at the sell and bid price at the end each transaction can be seen as made by any buyer and seller conforming to supply and demand.

2. Homogeneity in products – This condition is met as each company's stock is usually identical to all other sold and bought.

3. Perfect information is available – The interesting twist obviously lies here. Sure, not all players have the same information but as mentioned above the requirement for perfect information can not be easily dismissed as non existent in capital markets.

As aforementioned information plays the most important role in efficiency of stock markets. As information technologies evolve access to information has become increasingly and significantly easier. The household investor can access all the public information regarding a company with a couple of clicks.

To make things all the more complicated some effects have surprisingly endured even though information is available. Effects like the January effect (a rise in stock prices in January) or momentum strategies point to failures in market efficiency as they should have disappeared. Take the January effect for example: common knowledge that stock prices tend to rise in January should have lead to purchases in December and in turn to a rise in prices in December. Knowing December's price should lead to a rise in prices in November and so on and so forth.

Another aspect to consider is that of inside information which is obviously unavailable to all investors and as such reduces efficiency levels. As a result an interesting new concept of market efficiency has evolved: Semi- Efficiency

Let's have another look at the influence of information on stock market efficiency:

Inefficient Market – Prices do not reflect the information of past pricing

A stock market in which the January effect exists is an inefficient market since the only way to keep the January effect going is a lack of general knowledge of it. This lack of knowledge is in contradiction to market efficiency requirements.

Weak Form Efficiency - Prices reflect all the information in past price movements

Since the January effect or weekend effect can be deduced by looking at past price movements they will not exist in weak form efficient markets. Notice technical analysis is based on the fact markets are not weak from efficient.

Semistrong-Form Efficiency – Prices reflect all publicly available information

If you take a careful look at a stock's price behavior in the time before a major announcement you will see a change in prices in a certain direction (either up or down). Usually in the time following the announcement this trend will continue as a result of the announcement. The earlier price change is attributed to inside information which is not available to all players. Assuming all market players would have access to that information would have lead to a price increase in the moment of the publication and not some time sooner. Most stock markets are semi efficient stock markets as they display these price behaviors.

Strong-Form EfficiencyPrices reflect all the information available

Completely efficient stock markets are non-existent of course but this simplification helps us to better understand what is going on in the real world.In the near future I will try to demonstrate (and visualize) how we can tell the stock markets are becoming more and more efficient.

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