The Need for a ‘Well Functioning and Competitive Market’- series III
The financial markets perform much the same function as the markets for other goods and services. They bring large numbers of buyers and sellers together, where people who need money to implement their great ideas will meet people who have money to save. It aids in the mobilisation of savings and their channelization into more productive uses.
The financial market facilitates price discovery, provides liquidity, reduce transaction costs and encourages competition and improves efficiency generally. Finance, as a specialization, is totally dependent on the price discovery aspect.
What is this “Efficient Market Hypothesis”?
We are focused on the ‘informational efficiency’ and basically states that all new information will be quickly and correctly reflected in the security prices. Roberts (1967) and Fama (1970) have defined an ‘efficient’ market as a market where there are large numbers of rational, profit ‘maximisers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. The competition among the many smart participants leads to a situation where the current price of a security fully reflects all available information, both the past and the future. In other words, in an efficient market at any point in time, the actual price of a security will be a good estimate of its intrinsic value.
Fama also enunciated three types of efficiencies namely, the weak form, semi-strong form and the strong form of market efficiency. The weak form EMH stipulates that current asset prices already reflect past prices. The information contained in the past prices of security is fully reflected in the current market price of that security. The semi-strong form EMH maintains that all the publicly available information is fully reflected in a security’s current market price. The publicly available information can be the firm’s financial statements, announcements, economic factors etc. The strong form EMH requires that private information or insider information also is quickly incorporated into the market prices and therefore cannot be used to earn abnormal or above-average profits. Thus, all information, both public and private, is quickly and fully reflected in a security’s current market price.