10.1: Defining Market Efficiency Flashcards
What is an efficient market?
An efficient market is a market that reacts quickly and relatively accurately to new public information, resulting in prices that are correct on average.
It implies that all relevant information is reflected in security prices, making them accurate representations of a firm’s value.
What is disclosure in the context of market efficiency?
Disclosure is the revelation of all material facts so that everyone in the market is buying and selling based on the same material facts about the firm. This ensures fairness and transparency, contributing to market efficiency.
Define securities law.
Securities law is the body of law that ensures, through capital market regulations, that all investors have equal access to, and an equal opportunity to react to, new and relevant information.
It governs the buying and selling of securities.
Why is market efficiency important?
Market efficiency is important because it ensures that the prices of securities accurately reflect all available information, allowing investors to make informed decisions.
It also helps in maintaining fairness and integrity in the capital markets.
What are the conditions necessary for a market to operate efficiently?
For a market to operate efficiently, there must be integrity in the market, meaning all market participants are treated fairly and have equal access to information.
This requires effective disclosure of material facts and adherence to securities laws.
How does a lack of disclosure affect market efficiency?
A lack of disclosure can lead to inefficiencies in the market, such as “black markets,” where prices do not accurately reflect available information.
This results in some market participants being unaware of critical information, leading to unfair trading conditions.
What is the technical definition of market efficiency?
The technical definition of market efficiency suggests that market prices are always correct, requiring instantaneous and perfect price adjustments in response to new information.
However, this is not practically achievable, but efficient markets react quickly and accurately, making prices correct on average.
What is the significance of market efficiency being a matter of degree?
Market efficiency being a matter of degree means that not all markets are equally efficient. More efficient markets process information faster and more accurately than less efficient ones, resulting in prices closer to true values.
What is a sell-side analyst?
Sell-side analysts are securities analysts whose job is to monitor companies and regularly report on their value through earnings forecasts and buy/sell/hold recommendations. They work for investment banks that underwrite and sell securities to the public.
What is a buy-side analyst?
Buy-side analysts are securities analysts whose job is to evaluate the research and recommendations produced by the sell-side analysts. They work for institutions in the capital market that invest in securities.
What are the assumptions underlying efficient markets?
The assumptions underlying efficient markets include:
A large number of rational, profit-maximizing investors actively participate in the market.
Information is costless and widely available to market participants at the same time.
Information arrives randomly, so announcements are not related to one another.
Investors react quickly and fully to new information, which is reflected in stock prices.
Why are efficient market assumptions not entirely realistic?
The assumptions are stringent and not met in the strictest sense in the real world because markets are influenced by human behavior, irrational decisions, and varied access to information.
Despite this, many market participants actively follow securities and contribute to the market’s efficiency.
What is the role of behavioral finance in understanding market efficiency?
Behavioral finance examines how psychological factors and biases affect investors’ decisions and market outcomes.
It suggests that investors may make systematic mistakes in processing information, leading to market inefficiencies.
What did John Maynard Keynes suggest about investor behavior?
John Maynard Keynes noted that investors often follow groupthink and may fail to process information rationally or efficiently.
He believed that expert professionals might not always correct market vagaries, as they are often focused on short-term forecasts rather than long-term value.
What is the Grossman-Stiglitz paradox in market efficiency?
The Grossman-Stiglitz paradox argues that markets cannot be completely efficient because if they were, there would be no incentive for investors to gather information and analyze securities.
Complete efficiency would mean all prices reflect all information, eliminating the potential benefits of analysis and leading to market inefficiency.
