Financial Market Efficiency - Essay Example

Financial market efficiency Insert Names Insert Course Title Insert Instructor’s Name 16th October 2011 Introduction Financial market efficiency refers to the situation where market prices reflect the true value of an investment. Even though the true value of the investment at every point does not need to be the same as the market price in order for the market efficiency to exist, the errors should be unbiased (Leffler and George 1951). In order for the market efficiency to exist, there must be actions of the investors who emulate various tactics to beat the market. It is vital to note that it is very unlikely that all markets appear to be efficient to all potential investors. However, to the average investors, a certain market for example the Australian Stock Index may be efficient. It is also imperative to note that due to implications of taxes and other related costs experienced by investors some market may be efficient to some investors and not others. Forms of financial market efficiency are classified depending on the availability of the private and public information as well as the effects of past prices on the performance of the company’s securities. Some of the major efficiency that exists in the market includes allocative efficiency. This efficiency ensures that right goods are produced at the right price and for the right people. This paper will keenly discuss three forms of market efficiency as well as the importance of efficiency in the financial market. Weak form efficiency Under the weak form of market efficiency, the prices of the securities that include bonds, bank notes, debentures and forwards reflect all the details of the past prices. Hasan et al, 2004, stipulates that the past prices cannot be used to predict the future movement of the securities prices. This form of efficiency ensures that by developing trading strategies that are based on the return information or on the past prices, an investor cannot earn extra returns. Semi-strong form efficiency According to semi-strong efficiency, the current prices of the securities reflect public information that includes news report from the companies in addition to the past prices (Mishkin, 1998). This implies that in order for the investors to make investment decision, they need to have more information regarding the operation of the firm where they intend to invest. Strong-form of market efficiency Under the strong form of market efficiency, the prices of the assets entirely reflect the available information from the firms as well as the information possessed by the public (Pilbeam, 2005). This implies that all the data that is essential for investors to make their investment decision is exhausted. In this regard, there is no particular investor has the advantage over the other in terms of predicting the security prices. Another vital aspect of the strong form of market efficiency is that an investor cannot constantly find the stocks that are undervalued. Importance of efficiency in financial market Due to the increased need to diversify their investment portfolio, investors are very keen to invest in profitable investments. In the same way, most of the investors are attracted to the investments that they are able to predict their performance based on the current and past prices of the securities. One of the major importances of efficiency in financial market is that it allows investors to make sensible investment decisions (Marc, 2003). It is important to note that investors are always eager to notice an abnormality in the performance of the securities in the financial market. Investors take advantages of such opportunities to invest in such securities in order to gain high profits. In most cases, investors do not make high profits if the market is efficient. Market efficiency is also important for consumers when making purchasing decision. For example, when there is adequate information regarding the price of particular product consumers tends to perceive such products as having high value. Another significance of market efficiency is that it creates a base for efficient allocation of resources. This is possible if the future performance of firm is reflected by the stock prices (Davidson, 2002). It is paramount for the companies to constantly monitor the prices of their stock in the financial market in order to ensure that adequate information is available to the investors. In the same way, inappropriate investments are experienced if the stock prices are inefficiently formed. Financial market efficiency is also important since it does not allow some investors to have more advantages over the other as far as investment is concerned. This implies that no category of investors is able to exploit the market by adopting similar investment techniques (Peters and Edgar, 1994). Conclusion Based on the above discussion, it is clear that availability of adequate information is vital to an investor. The emergence of new information in the financial market is highly recognized by the investors when they are making investment decision. As discussed above there exist three forms of market efficiency. These include weak, semi-strong and strong forms of market efficiencies. Under the weak efficiency the current prices of the securities reflect the past prices while under the semi-strong form of efficiency, the prices of the assets reflect information from the public as well as from the past prices. On the other hand, strong forms entail the availability of all the information that is essential for investors during their decision making process. The importance of the efficiency in the financial market cannot be overlooked. Due to the complexity that is associated with making of investment decisions, efficiency in the financial market act as a guide to the investors. In addition, it allows equality of the investors in the short run. In my opinion, it is imperative for investors to seek adequate information before adopting a particular investment. Such information can be obtained from investment analysts. In addition, it is necessary to consider the transactions costs that are expected to be incurred during undertaking of an investment. The expected profit should be more that the transaction costs. It is also fundamental for companies to release accurate financial information to the public. Due to lack of awareness and deceiving information, many investors have incurred heavy losses a situation that can be avoided if firms provide accurate and reliable information regarding the stock prices. Reference list Davidson, P. (2002). Financial markets, money and the real world. Camberley: Edward Elgar Publishing. Hasan, Iftekhar; Hunter, William C. (2004). Bank and financial market efficiency. New York: Emerald Group. Leffler, George L. (1951). The Stock Market. New York: Ronald Press Co. Marc, L. (2003). Guide to Financial Markets. New York: Bloomberg Press. Mishkin, F. (1998). The economics of money, banking, and financial markets. New York: Addison Wesley. Peters, Edgar E (1994). Fractal Market Analysis: Applying Chaos Theory to Investment and Economics. New York: John Wiley and Sons. Pilbeam, K. (2005). Finance and Financial Markets. Palgrave Macmillan. Read More