7.3 Financial Market Efficiency

 7.3 Financial Market Efficiency

If the market price of anything differs from the equilibrium price market participants will bid the market price up or down until equilibrium is achieved. 

The investor who values the asset most highly will come to own it because he’ll be willing to pay the most for it. Financial markets are therefore allocationally efficient. 

Where free markets reign, assets are put to their most highly valued use, even if most market participants don’t know what that use or value is. 

Financial markets are also efficient in the sense of being highly integrated which means prices of similar securities, or assets track each other closely over time, and prices of the same security trading in different markets are nearly identical.

Arbitrage, the profit opportunity that arises when the same security at the same time has different prices in different markets. By buying in the low market and immediately selling in the high market, an investor could make easy money. 

As soon as an arbitrage opportunity appears, it is immediately exploited until it is no longer profitable. (Buying in the low market raises the price there while selling in the high market decreases the price there.) Therefore, only slight price differences that do not exceed transaction costs persist.

The size of those price differences and the speed with which arbitrage opportunities are closed depending on the available technology. 

The transaction costs (fuel, tolls, hotels, and fees) are too high explains why people don't arbitrage the international price differentials of Big Macs, or any other physical things. However, online sites like eBay, or Amazon have recently made arbitrage in nonperishables more possible than ever by greatly reducing transaction costs.

After carefully studying all the transaction costs, the freight, insurance, brokerage, weighing fees, foreign exchange volatility, weight lost in transit, even the interest on money over the expected shipping time, the unit, the British ton (long ton, or 2,240 pounds), and the U.S. ton (short ton, or 2,000 pounds) are not the same thing. 

However, arbitrage and other unexploited profit opportunities do exist on occasion, not completely impossible.

In an efficient market, all unexploited profit opportunities and arbitrage opportunities, will be eliminated as quickly as the current technology set allows. 

In an efficient market, the optimal forecast return and the current equilibrium return are one and the same. For example, the rate of return on a stock is 10% but the optimal forecast or best rate of return, due to a change in information, was 15%. Investors would quickly bid up the price of the stock, thereby reducing its return. 

Financial market efficiency means that it is difficult or impossible to earn abnormally high returns at any given level of risk while returns increase with risk. 

Holding risk (and liquidity) constant, though, returns should be the same, especially over long periods. 

Many studies have shown that actively managed mutual funds do not systematically outperform the market.