C Explain factors affecting a market's efficiency.

Question 1

Factors for Efficiency

Answer 1

Large numbers of market participants and greater information availability tend to make markets more efficient.

Market efficiency assumes that investors adjust their estimates of security prices rapidly to reflect their unbiased interpretation of the new information. New information arrives randomly and independently. Therefore, price changes are independent.

More analyst coverage and more liquidity contribute to market efficiency.

Question 2

Factors Against Efficiency

Answer 2

Impediments to arbitrage and short selling and high costs of trading and gathering information tend to make markets less efficient.

Question 3

Factors affecting Market Efficiency

Answer 3

• Transaction costs and information
acquisition costs
• Information availability and financial
disclosure
• Market participants
• Limits to trading

Research supports the conclusion that short selling helps to prevent market prices from becoming overvalued, while limiting short selling has the opposite effect

Question 4

• Transaction costs and information

acquisition costs

Answer 4

• Low information acquisition costs
increase price efficiency.
• When transaction costs are low, well informed
traders can establish
positions without much cost, which
makes their trading more profitable.

Question 5

• Information availability and financial

disclosure

Answer 5

Systems that present accurate
information at low cost lead to greater
market efficiency.

Question 6

Market Participants (As the number of market participants increases, the speed at which markets adjust to new information is likely to increase)

Answer 6

• More participants generally increase
price efficiency.
– Many traders using the markets for
reasons other than informed trading
ultimately provide the liquidity that
informed traders need to profit.
– More informed traders introduce more
information into prices.

Question 7

Limits on Trading

Answer 7

• Impediments to trading—especially those
that bind upon informed trades, can lead
to price inefficiencies.
• Short-selling restrictions often are the
most important limits to trading.
– Many investment sponsors do not permit their
managers to sell short.
– Short-selling restrictions tend to inflate
prices. Restrictions on short selling limit the ability of arbitrage to correct pricing anomalies.
• Other impediments include capital
requirements, transaction costs (High bid-ask spreads increase transaction costs and decrease efficiency.), and lack
of liquidity.