Following factors impact the degree to which markets behave efficiently:
- Number of participants: Markets generally behave more efficiently as the number of participants increase. More participants increase the chance of new information getting absorbed quickly and efficiently. Some countries like China, Saudi Arabia etc. put restrictions on foreigners trading in their markets. Such restrictions tend to decrease market efficiency.
- Financial disclosure and information availability: Availability of information (financial news, etc.) and financial reports is critical to market efficiency. Additionally, such information should be made available to all participants on an equal basis. To ensure this, regulators like US SEC have framed fair disclosure regulations, which require that any material information should be made available to investors, analysts and public in general. Regulations also exist to dissuade insider trading which is defined as trading of securities by participants who have access to any material and non-public information. Notably, exchanges like S&P500, LSE, Nikkei have very accessible information relating to trading activities, etc., and are highly efficient. Conversely, emerging market trading exchanges are still implementing measures to improve information availability and are less efficient. Note that the efficiency may vary for different markets. OTC markets dependent on dealers may not have very efficient information systems.
- Trading limits: Arbitrageurs look to exploit pricing discrepancies of securities by buying or selling the securities until their prices reflect their true value. Arbitrage can be thought of as riskless profit and is very critical to market efficiency. Short selling is the process of selling shares that the investor doesn’t own by borrowing from the broker with the promise to replace them at a later date. Some regulators put a limit or restrict short selling to protect markets from sharp downward movements. However, such restrictions restrict market inefficiencies as in absence of short selling some assets may become overvalued.
- Transaction and information cost: To correct market inefficiencies, investors incur two type of costs: transaction cost i.e. buying/selling of security and information cost related to acquiring information, analyzing it etc. According to the modern view of market efficiency, the profit opportunity resulting any inefficiency should be large enough to cover the cost of the transaction and acquiring information. Otherwise, there will be no incentive for the investor to enter into such a trade and price may not reflect all available information. The classical view, however, holds markets as inefficient if active investors can capture any part of the cost incurred.
Check your concepts:
(47.5) Which of the following factors is least likely to increase a market's efficiency?
(a) Decrease in the cost of information
(b) Increasing the limit of short selling from $20,000 to $100,000 per person
(c) Putting restrictions on foreigners' trading to decrease the volatility
Solutions:
(47.5) Correct Answer is C: Putting restrictions on foreigners' trading will decrease the market efficiency as that will decrease the total number of market participants available in the market. Increasing the limit of short selling will improve market efficiency. A decrease in the information cost will also improve market efficiency.
