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Essay: Exploring How Market Efficiency Influences Market Performance Exploring How Market/Investor Efficiency Impacts Market Performance

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  • Published: 1 April 2019*
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Sarah Xu

Paper 3

Matthew Ripley

Monday 1:00-1:50

Word Count:

Market Efficiency

Overview of Market Efficiency and EMH

The efficient market hypothesis (EMH) states that stock prices portray the best estimates of their discounted future value stream and must provide an accurate measure of corporate performance. So that means prices respond instantaneously to new information and that the prices are “correct” in that they properly incorporate all readily available information. Since financial markets function as prediction markets, future expectations are usually reflected in the current prices. The EMH suggests that it is impossible for people to surpass the market in the long run. So if this hypothesis is true, that means decisions made by corporations’ managers are either rewarded or punished quickly. This way, stock prices provide managers with information on how to behave. This hypothesis also gives justification to prompt regulators to remove any obstacles to market efficiency. However, there are a few circumstances where financial markets are not efficient and other circumstances when they are efficient. For a market to be efficient, it has to be unpredictable. Prices should be random and you should not be able to use an equation or insider trading even, to make a profit. So, for an efficient market, there are a few questions to ask. First, how big is the market? The larger the market, the more efficient it is. Second, is the market liquid? Can funds be turned into money quickly? Third, can people easily obtain information about the market? Fourth, are the transaction costs cheap? They would ideally be less than expected profits. Taking all these factors under consideration helps decide if it’s an efficient market.

Arbitrage

Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in price. It exists as a result of market inefficiencies. One of the basic mechanics of the EMH is that any profit opportunity that exists should instantly vanish. However, if there are assets that exist but the price does not match their value, investors will buy or sell and “arbitrage away” those differences. After that, other investors will find out about this arbitrage behavior, and any pricing mistakes discovered by the arbitrageur will disappear. However, these arbitrage and learning mechanisms should be so widespread that there are never any excess returns available in the market in the first place, so some investors that are less intelligent are weeded out. A key implication of EMH is that investors cannot beat the market by trading on known and public information, because any profit opportunities should already have been incorporated into current market prices. Any investor who does not agree is simply disregarding arbitrage and learning effects’ existence. Therefore, the best thing to do is to participate in passive investment strategies like buying index funds.

Although some may argue about the efficiency of financial markets, now, even Eugene Fama, who is the father of EMH, admits that financial markets are probably inefficient based on the weight of empirical evidence. The EMH has been challenged by all kinds of empirical evidence. The stock market is more unpredictable than it should be, given EMH. Investors can’t seem to agree about the value of multiple securities, which should be impossible under EMH. Asset bubbles are quite common and prices are much higher than intrinsic value, but that difference does not get arbitraged away.

Arbitrage can only create efficient prices to only some extent. When prices are low, a value investor can then purchase a corporation if this investor believes the value is much higher than the current price. When prices are high, then there’s no comparable strategy. People can sell a short stock, but this leaves people defenseless against the speculative market. This usually lends to becoming broke before the bet placed pays off. Furthermore, with the internet boom, there usually weren’t enough shares to borrow.

2008 Financial Crisis

The existence of a housing bubble questions the concept that markets are efficient. What exactly is a house worth and what would someone be willing to pay for it?  Looking at 2008, banks were making mortgages and at the same time selling them to the government. In contrast to the EMH, speculative bubbles are inherent to financial markets. Furthermore, CDO sales are another challenge to EMH. Banks and ratings agencies did not fully take advantage of all the information that was available to them about the underlying mortgages to rate and price them. Information was intentionally  hidden from investors, but investors did not really care. Therefore, CDOs spread, but not because each bank was acting rationally on its own.

Since the banks were intentionally hiding information from investors, and if information is not easily accessible and available to all investors, then it can be said that the market is inefficient. This was inefficient because the investors were not given access to all information. Investors need to have the correct information to make investment decisions. There were also none or very few arbitrageurs during the housing bubble. Arbitrage existed, but it was ineffective because it was based on incorrect information.

In 2008, the banks were making subpar mortgages and then selling them to the government. By doing so, they were simultaneously selling their securities to the government and purchasing more by making more mortgages. In this case, it affects the efficiency of the market because they were not giving all the information available or, in some cases, gave incorrect information in order to sell the securities. The prices of houses were too high and the demand for them kept increasing, which questioned the efficiency of the market. Both of these events led to the inefficiency. The investors’ speculation with good available information could lead the markets to be more efficient.

Development of Options Markets and Formulas for Pricing Options

The Capital Asset Pricing Model (CAPM) shows how to quantify the tradeoff between risks and expected returns, and early forms of the EMH produced a clear way to model stock prices. Once there was an agreeable model of stocks prices, it became possible to figure out how to price options that depended on stocks. Furthermore, when the Black-Scholes-Merton model was first being used in the 1970s,  its prices differed from market prices. This is partially because the model’s assumptions were at odds with reality. Stock prices also follow a random walk in continuous time, but there were many controversies about this at the time, which also forms the core of the EMH. The EMH was the foundation of CAPM and Black-Scholes-Merton, so prices followed them for a while.

In the early 1970s, options were labels as gambling or just speculation. Derivatives were banned by law unless they could lead to the physical delivery of a good. There were quite a few promising options such as currency derivatives or stock options. However, what exactly does this mean for market efficiency since prices have now disconnected from their theoretical values?

When more than one group is examining some instrument such as security, it creates arbitrage opportunities when these groups evaluate them differently. ABS CDOs were created to take advantage of separate evaluation procedures for mortgage bonds and for CDOs carried out by separate groups. By developing options markets and formulas, it actually keeps the market efficient. This is because investors believe that the market is inefficient and possible to beat, but by developing their formulas and consistently being proven wrong, it actually proves that the market is consistent and unpredictable.

There are also two types of options: calls and puts. Calls are the right to buy shares at a certain price and puts are a right to sell a share at a certain price. These options are traded on exchanges and are priced based on the market’s thinking on whether a given event will occur. They are both tools of arbitrage and provide a form of market insurance for investors who know how to use them. So investors can easily purchase both types of options, thus giving them the ability to sell their stock at a higher price, while also giving them the ability to purchase at a lower price.

High-Frequency Trading

There are two ways to electronically trade. Traders can either use the bid-ask spread or the electronic trading rolled out the “maker-taker” model. There is also electronic front-running, rebate arbitrage, and slow-market arbitrage. Would high-frequency trading add efficiency by carrying out arbitrage or is this just creating an illusion of efficiency? High frequency trading is similar to developing options markets and formulas, as well. The difference is that the trading is done at a high speed using super computers and algorithms, but it has the same basic underlying concept. HFT also added efficiency to the market as long as the available information provided was trustworthy and was available to everyone in the market.

Looking at high frequency trades, it’s known know that they have arbitrage because their main focus is to make a profit by simultaneously buying and selling stocks at an extremely high pace, using computers. HFT is all about arbitrage.

Are markets efficient? When?

Generally, they are not wholly efficient or inefficient, but rather somewhat of a mixture. Financial markets are the most efficient market due to the availability of information and new technologies. However, they are not completely efficient. For example, the housing bubble is an example that the financial markets can also be very inefficient. They were more inefficient because the information was withheld, but there were some efficient parts. Most markets of goods are inefficient because they produce a lower quantity and charge a higher price due to the market power of some firms. Internet related industries tend to be more efficient. The internet has made many markets closer to perfect competition because the internet has made it very easy to compare prices quickly and efficiently, which is perfect information.  This is where the statement that there is not a wholly efficient or inefficient market comes into play. Arbitrage occurs in inefficient markets, but also that with the options market and HFT, there is an efficient market because they cannot predict the price. In these scenarios, it can be said that the market is mostly efficient.

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