Question

In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient? Explain.

Answer 1

Almost all the theories related to security markets, be it Modern Portfolio Theory by Markowitz, Capital Market Theory by Sharpe , or Capital Asset Pricing Model, the underlying principal is that Markets are efficient and all the players have same level of information available , enabling them to make decision making. However, in real world, it is not true. Players in the financial market possess different levels of information and that makes the difference between a successful and not so successful investment.

Insider Trading is prevalent in financial markets even though the regulators try and impose huge penalty and even prosecution to discourage such unfair means. Price sensitive Information are exchanged between parties in exchange of favours which creates unfair trade advantage to the person who possesses such information.

In recent times, the Mr. Rajat Gupta case, who was the former Board of Directors in Goldman Sachs passed on price sensitive information to his confidant which was later discovered and the matter was thoroughly investigated resulting in his imprisonment and huge penalties for such act.

Similarly, Barclays, a 300-year-old British bank, was found guilty of rigging LIBOR rates ,resulting in huge profits in its books.

There are numerous other cases in recent years where the players in the financial markets were driven by greed and profit maximization objective ,in pressure to give higher returns than the broader markets. These clearly prove that markets are efficient only on paper in theory, but in real life, greed and the pressure would always supersede which would result in unfair means and frauds to achieve such targets and make the markets inefficient and the honest players would always lose out to such malpractices.