Three Forms Of Financial Market Efficiency - Essay Example

Three Forms of Financial Market Efficiency Table of Contents Introduction 3 Three forms of financial market efficiency 3 Why is it important thatfinancial markets are efficient? 5 References 7 Introduction Financial market efficiency is viewed as one of the most crucial areas in the financial and economic world. Financial markets can be said to be efficient if the current prices of the assets entirely reflect all the relevant information that are presently available (Parks & Zivot, 2006). There are three forms of efficiency that can be addressed while discussing the financial market efficiency. This paper includes all the important information about these three forms. Furthermore, it is also consisted of the explanations behind the fact that financial markets are required to be efficient. Three forms of financial market efficiency The three forms of efficiency are ‘allocational’, ‘operational’ and ‘informational’. Each of these is explained below separately. Allocational Efficiency: Allocation efficiency is referred to the main concept of ‘Pareto efficiency’. In simple words, Pareto efficiency is achieved by allocating resources in such a way in which one individual is better off while making at least another one individual worse off (Bailey, 2005). The theory of allocational efficiency is greatly used for measuring the capacity of the financial markets in allocating the resources to those alternatives that will bring maximum yield. A situation that is efficient in terms of allocation of resources can be defined as the best possible attainment of a particular objective (Hasenpusch, 2009). The concept, when used in case of financial market it implies that the investment of funds will be made to its ‘highest-valued use’. In other words, achievement of such efficiency means that there is no other way in which funds could have been invested for making the society better off. Hence, it can be said that attaining allocational efficiency is the ultimate objective of all the activities that are related to the financial market. Any financial market that wants to achieve allocational efficiency must channelize the resources into projects where ‘marginal efficiency of capital adjusted for risk differences is the highest’ (Bhole, 2004). Practically, activities of business organizations as well as households may lead to allocational efficiency as business firms tend to invest in those projects that will give them maximum rate of return while adjusting the risk. Even the households have the tendency of investing in such a way that will fetch them high return on their investment while making adjustment with the existing level of risk. Operational Efficiency: One of the main preconditions for attaining allocational efficiency is the operational efficiency. An operationally efficient financial market is the one in which sellers and buyers are able to purchase the products and services at a price which is as low as possible considering the costs of providing the services (Hasenpusch, 2009). In such a market transaction costs as well as the administrative costs are minimized. Furthermore, lenders and borrowers are subjected to maximum convenience at the time of mobilizing the resources (Bhole, 2004). Failure to attain operational efficiency means transaction costs are quite high and as a result number of financial transactions will be lowered. This in turn would make the companies to delay their investment plans which may make the society worse off. The study on operational efficiency actually inspects whether the financial services that are offered by various organizations are provided without violating criteria regarding industrial efficiency. In other words, any study on this concept examines the competition among various financial service providers as well as among various financial markets. Furthermore it also examines the commission fees (Bailey, 2005). Informational Efficiency: ‘Information’ has been one of the key aspects in the process of making financial markets efficient. Informational efficiency is referred to the degree to which prices of the assets reflect the information that are available to the investors. If the available information is fully reflected by the market prices then it may said to be an ‘informational efficient market’. In such an efficient market, when any new information regarding a particular security comes in, the price of that security is adjusted accordingly. Such adjustment has to be very quick in an efficient market where millions of investors as well as the analysts try to make the best out of it. If one makes huge gains by utilizing the information which is commonly available, then the financial market is considered to be an inefficient one. According to L M Bhole, in a perfect market “the possibilities of such a gain are nil because the prices in such a market already reflect fully and immediately all relevant and ascertainable available information” (Bhole, 2004). Furthermore, no individual would know anything which is not known previously and hence not reflected in the market price. Why is it important that financial markets are efficient? Each and every financial market is needed to be made efficient so that overall society is benefitted. The markets are required to be efficient so that valuable resources get properly allocated. Proper allocation of resources reduces the overall costs of the projects and allows investors to invest funds in number of projects and this in turn increases the employment opportunities. It is important to make the financial markets efficient as in such markets transaction costs as well as the administrative costs are kept at their lowest possible level. Such a market tends to attract more number of investors and hence the overall economy gets bigger in size by creating more opportunities in terms of wealth creation and employment. Furthermore, in efficient financial market information plays crucial role in determining the asset prices. This makes the decision making process even more effective. Moreover, as the information gets properly reflected in the prices, there is less chance of unfair practices. Both sellers as well as buyers have the opportunity of making gains in an efficient financial market. References Bailey, R. E. (2005), The economics of financial markets, Cambridge University Press Bhole, L. M. (2004), Financial Institutions and Markets: Structure, Growth and Innovations,4e, Tata McGraw-Hill Education Hasenpusch, T. P. (2009), Clearing services for global markets: a framework for the future development of the clearing industry, Cambridge University Press Parks, R. W. & Zivot, E. (2006), Financial Market Efficiency and Its Implications, Retrieved from http://faculty.washington.edu/ezivot/econ422/Market%20Efficiency%20EZ.pdf on October 17, 2011. Read More