A Describe market efficiency and related concepts, including their importance to investment practitioners. Flashcards Preview

L1 48 Market Efficiency > A Describe market efficiency and related concepts, including their importance to investment practitioners. > Flashcards

Flashcards in A Describe market efficiency and related concepts, including their importance to investment practitioners. Deck (2)
Loading flashcards...
1

An informationally efficient market is
one in which prices reflect new
information quickly and rationally.

Prices reflect all past and present
information.
Rationally: prices react only to
unexpected information about value
and not to announcements that are not
surprising.

In an informationally efficient capital market, security prices reflect all available information fully, quickly, and rationally. The more efficient a market is, the quicker its reaction will be to new information. Only unexpected information should elicit a response from traders.

An efficient capital market would price Hume’s stock based on the expectation for earnings per share. Since actual earnings equal expected earnings, the stock price should not change as a result of the announcement.

If financial markets are informationally efficient, active investment strategies cannot consistently achieve risk-adjusted returns superior to holding a passively managed index portfolio. In addition, a passive investment strategy has lower transactions costs than an active management strategy. Share prices should not adjust when a company announces results in line with expectations in an informationally efficient market, because the market price already reflects the expected results.

An efficient capital market fully reflects all of the information currently available about a given security, including risk.

2

Importance to Investment
Practitioners

• Active management is impossible in
perfectly price efficient markets.
– Active management strategies try to
obtain an above average return by buying
undervalued instruments and selling
overvalued instruments.
• In perfectly price efficient markets,
passive investing strategies are the
only sensible strategies.
– Investors use passive strategies to obtain
a fair return for bearing risk.

If the market is fully efficient, active investment strategies cannot earn positive risk-adjusted returns consistently, and investors should therefore use a passive strategy.