What is an "efficient" market? Can you say that the stock market in Zimbabwe is efficient?. Definitely our stock market is very small relative to others. For example, the ZSE carries only 75 counters, whereas the Johannesberg Stock Exchange (JSE) has more than five thousand firms, yet by world standards, even the JSE is still regarded as an "emerging market". So you can see that there are very few players on our ZSE, thus very little competition among the investors. On this score, our ZSE is not an "efficient" market.
8.2. Objectives of the unit.
At the end of this unit, you should be able to:
1. Define an efficient market.
2. Examine the implications of market efficiency.
3. Discuss the three forms of market efficiency.
1. Discuss technical analysis.
2. Discuss the tests of the EMH.
8.3. Defining market efficiency.
`An efficient market is one in which security prices reflect "all available information". This means that the price of a security is an unbiased estimate of the true value of the security. This means that the prices of securities follow a "random walk" and are not easy to predict. Any information that could be used to predict security prices should already be reflected in the prices of those securities. Price changes should be random and unpredictable. Prices of securities can only change as a result of new information coming into the market.
If the market is not efficient, the market price may deviate from the true value. Thus, some investors may be able to make higher returns than others because of their ability to spot "under-valued and over-valued" securities. They can do this by studying the firms that have issued the securities, or digging up any other relevant information that may affect the value of the security. This has come to be known as the Efficient Markets Hypothesis (EMH). The EMH has three forms: the strong form, the semi-strong form, and the weak form. In market-based economies, market prices help determine which companies (and which projects) obtain capital. If these prices do not efficiently incorporate information about a company’s prospects, then it is possible that funds will be misdirected. By contrast, prices that are informative help direct scarce resources and funds available for investment to their highest-valued uses. Informative prices thus promote economic growth. The efficiency of a country’s capital markets (in which businesses raise financing) is an important characteristic of a well-functioning financial system.
Investment managers and analysts, as noted, are interested in market efficiency because the extent to which a market is efficient affects how many profitable trading opportunities (market inefficiencies) exist. Consistent, superior, risk-adjusted returns (net of all expenses) are not achievable in an efficient market. In a highly efficient market, a passive investment strategy (i.e., buying and holding a broad market portfolio) that does not seek superior risk-adjusted returns is preferred to an active investment strategy because of lower costs (for example, transaction and information-seeking costs). By contrast, in a very inefficient market, opportunities may exist for an active investment strategy to achieve superior risk-adjusted returns (net of all expenses in executing the strategy) as compared with a passive investment strategy. In inefficient markets, an active investment strategy may outperform a passive investment strategy on a risk-adjusted basis. Understanding the characteristics of an efficient market and being able to evaluate the efficiency of a particular market are important topics for investment analysts and portfolio managers. An efficient market is a market in which asset prices reflect information quickly. But what is the time frame of “quickly”? Trades are the mechanism by which information can be incorporated into asset transaction prices. The time needed to execute trades to exploit an...
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