Question

Discuss how efficient the U.S. financial markets are in pricing financial securities. Are security prices reliable? What factors promote or reduce pricing efficiency? How can we account for significant pricing fluctuations?

Answer 1

market efficiency relates to the abilty of the market to reflect all the available information on the stock prices efficiently. the lower the transaction costs in a market, that is the cost of obtaining information and trading is lower, the market is more efficient.

in the US, all the information is readilly reflected in the stock prices .

for example the share prices of johnsons and johnsons fell on report of the product containing asbestos which causes ovarian cancer. this is and example of efficient markets .

yes the security prices in the U.S are completely reliable as they reflect on the readily available information.

the factors promoting market efficiency are :

• number of participants : the more the number of participants the more efficiently a market operates. the information is more gets more readily absorbed and reflected if the number of participants are more. the decrease in the number of participants , suppose we restrict the foreign investors from investing in our markets, then the market efficiency will decline.
• financial disclosures and information availability : all the information related to financial disclosures, any material information of the company should be disclosed and readilly available to the public.
• transaction and information costs: there are two types of costs incurred in the market, transaction costs and costs related to acquiring informatioan and acting on it. according to the modern view , the market is inefficient if the players in the market are able to somewhat recover their costs. a decrease in information costs will improve market efficiency.
• trading limits: arbitrage is the riskless buying and selling of securities exploiting the differences in the pricing of sceurities and booking profits on these trades tll the secutities reflect there true value, which is critical to market efficiency short selling is selling shares which are not purchased but borrowed. the stock is then sold at a higher price and the money returned to the broker. some regulators restrict short selling however, in the absence of short selling certain assets become over valued. limits to short selling will also imrove market efficiency.

if the markets are efficient any pricing fluctuations will be corrected and the security will return to its true price. in efficient markets, the participants cannot earn above average returns without taking additional risks. the pricing fluctautions are uncertain and respong quickly to the information available.