What is Capital Market?
Capital Market is the part of a financial system concerned with raising capital by dealing in shares, bonds, and other long-term investments.
Capital market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions.
What is Market Efficiency?
Market efficiency refers to the degree to which market prices reflect all available, relevant information.
If markets are efficient, than all information is already incorporated into prices, and so there is no way to “beat” the market because there are no under- or overvalued securities available.
Different Types of Efficiency
Different types of efficiency can be distinguished in the context of the operation of financial markets.
(1) Allocative efficiency: If financial markets allow funds to be directed towards firms which make the most productive use of them, then there is allocative efficiency in these markets.
(2) Operational efficiency: Financial markets have operational efficiency if transaction costs are kept as low as possible.
Transaction costs are kept low where there is open competition between brokers and other market participants.
(3) Information processing efficiency: The information processing efficiency of a stock market means the ability of a stock market to price stocks and shares fairly and quickly.
An efficient market in this sense is one in which the market prices of all securities reflect all the available information.
What is Efficient Capital Market?
An efficient capital market is one in which security prices adjust rapidly to the arrival of new information, and, therefore, the current prices of securities reflect all information about the security.
For example, if major news breaks out for a company, an analysis would occur on the stock’s price to see how it should be valued given the news.Capital market efficiency measures the extent of the accuracy of the stock’s price.
Efficient Market Hypothesis
The efficient market hypothesis provides a rationale for explaining how share prices react to new information about a company, and when any such change in share price occurs.
The efficient market hypothesis assumes that markets are efficient.
Varying Degrees of Efficiency
Stock market reaction to new information depends on the strength or the degree of the stock market efficiency.
There are three degrees or ‘forms’ of stock market efficiency:
(1) Weak form,
(2) Semi-strong form and
(3) Strong form.
Weak Form Efficiency
If a stock market has weak form efficiency, it is not efficient at responding to events that affect companies and should affect share prices. It does not react to much of the information that is available about a company.
Instead, when stock market efficiency is weak, share prices respond to all available historical published information and information about past changes in the share price.
Semi-strong form Efficiency
If a stock market displays semi-strong efficiency, current share prices reflect:
- All relevant information about past price movements and their implications
- All publicly available knowledge about companies and market returns
Strong form Efficiency
If a stock market displays a strong form of efficiency, share prices reflect all information, whether it is publicly available or not:
- From past price changes
- From public knowledge or anticipation
- From specialists’ or experts’ insider knowledge (e.g., the inside knowledge of investment managers about unpublished facts)
Features of Efficient Markets
Stock markets that are efficient (or semi-efficient) are therefore markets in which:
(a) The prices of securities bought and sold reflect all the relevant information available to the buyers and sellers, and share prices change quickly to reflect all new information about future prospects.
(b) No individual dominates the market.
(c) Transaction costs of buying and selling are not so high as to discourage trading significantly.
(d) Investors are rational and so make rational buying and selling decisions, and value shares in a rational way.
(e) There are low, or no, costs of acquiring information.
Impact of Efficiency on Share Prices
If the stock market is efficient, share prices should vary in a rational way.
(a) If a company makes an investment with a positive net present value (NPV), shareholders will get to know about it and the market price of its shares will rise in anticipation of future dividend increases.
(b) If a company makes a bad investment, shareholders will find out and so the price of its shares will fall.
(c) If interest rates rise, shareholders will want a higher return from their investments, so market prices will fall.