Course Hero Logo

Capital Markets Efficiency

Inefficient Markets

Inefficient Markets versus Perfect Markets

Unlike inefficient markets, where a trading price does not always reflect a true value, a perfectly efficient market should fairly price all trading opportunities because investors have all the information when setting a price.

Stocks and bonds that are traded in securities markets can be subject to fluctuation in price. Broad considerations, such as consumer confidence about the economy as a whole and good or bad news about the future of stocks, may affect price fluctuations. The efficient market hypothesis is the idea that all securities trading opportunities are fairly priced because the price of a security always accurately reflects future performance in alignment with investors' information. Because all the information that is available to investors is already reflected in the prices of securities and expected returns, it is important that investors not try to time the market in making investment decisions.

There are three different types of efficient markets: strong form, semi-strong form, and weak form. A strong form efficient market is a marketplace in which all information, public and private, past and current, is reflected in asset prices. With this kind of efficient market, not even having the advantage of insider trader information will benefit an investor. The semi-strong form efficient market is a marketplace in which all public information, both past and current, is reflected in asset prices. Under this type, an investor cannot do anything to improve the odds of increasing their potential return. Finally, a weak form efficient market is a marketplace in which prices reflect only current information and past information has no relationship with current market prices. A perfectly efficient market is a marketplace based on the concept that all trading opportunities are fairly priced because investors have already accounted for all available information in setting a price.

In contrast, in an inefficient market, a security's market price does not always reflect its true value, and thus investors can employ strategies to improve returns. Thus, those subscribing to the inefficient market theory believe it is possible to outperform the stock market in general over time. It also may be possible that both methods are right to an extent, depending on the type of security being traded. For example, large capitalized stocks, or stocks from a company with a market capitalization value of more than $10 billion (such as those sold by U.S. Fortune 500 companies), are widely held and closely followed. The visibility and popularity of these stocks means that the current trading price will likely reflect almost all of the possible information about them. In comparison, a security that is minimally capitalized and not traded in high volume may offer opportunities for investors with special knowledge or trading models to find success in the market.

Efficient Market Theory

In an efficient marketplace, information that is already priced into the securities trading price varies depending on the efficient market theory being used.

Arbitrage in Inefficient Markets

An inefficient securities market will have greater opportunity for extreme loss or extreme gain.

In its simplest form arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Thus, arbitrage can also be referred to as the process of purchasing securities in one market and selling them in another market, usually immediately after purchase, to profit from price differences in the markets. For example, a trader may buy a stock on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, and the trader can make a profit from this difference. The most common securities arbitrage opportunities will exist in an inefficient marketplace. If the marketplace is inefficient, investors can take advantage of the information they have about the security that is not already priced into the security's current trading price, thus giving them an investment advantage. For example, traders engaged in day trading are usually seeking to exploit what they consider to be arbitrage opportunities. Day trading is the practice of purchasing and then immediately selling a security on the same day on the basis of price fluctuations. Thus, in an inefficient market, in the short term, investors can generate inflated returns as well as experience oversized gains and losses, depending on the effectiveness of their arbitrage trading strategy. This is because, in an inefficient market, the current securities price will not always reflect all the information that could affect a securities price.

Those that have information not already reflected in the current security price can use arbitrage tactics to make buying and selling decisions based on nonpublic insights. Thus, in the short term, as a result of arbitrage transactions, the market will see volatility (unpredictable increases or decreases) in the price of the traded securities. Some economic theorists believe that in the long run, even in an inefficient market, arbitrage opportunities may be fleeting. For example, there may be a discernible pattern in the stock market, such as if Widget Inc. stock had a higher average price on a single day of the month. Over time, as investors become aware of this pattern, they would purchase Widget Inc. stock the day before the peak and sell it the day after. If this type of purchase and selling occurs in high enough volume, the price of the stock will begin to reflect this activity. Investors will have to start buying the stock sooner each month to stay ahead of its peak day, and they will also need to sell sooner to realize the benefit of the arbitrage approach. Eventually, the strategy will no longer be effective. The impact of the strategy will be fully reflected in the Widget Inc. securities trading price at all times.