Question

1. A. Define efficient capital market. How do we know if we haven an efficient capital market?

B. Some people say that an efficient capital market is impossible to have, ever. Why do some say that efficient capital markets are impossible?

C. Define effective capital market. How do we know if we have an effective capital market?  

D. How would an effective capital market cause long term sustainable economic growth?  

Answer 1

(A) A market where information regarding the value of securities are incorporated into its prices accurately and in real time. Since the value of securities fluctuates depending on the present value of future cash flows, an efficient capital market enables these fluctuations to be reflected in the securities' current price.

There is really no test for market efficiency in all its forms. To know what is efficient one must know what is the true price. For this you need a model of risk return. Therefore, any test of market efficiency or of a pricing model is in fact a JOINT test and you will never know if the pricing model is wrong or the market is not efficient. Of course, for the weak from it is enough to prove that no strategy involving past price and volume history leads to a profitable strategy. This has long been established and it is thus useless to investigate again. For the semi-strong it is clear that to establish CARs you need some pricing model and thus my above comment about a JOINT test. For the strong form, well we should not even try as it is clear that insiders have information which leads to profit. If that were not true we will not have laws against insider trading and we would not see that many white collar law suits and convictions on the same. So, testing market efficiency as trying to establish a true pricing model are more of a fools errand. What counts is clearly behavior which is by far not that imposed to pricing models or even a martingale process. Since behavior was not yet convincingly introduced into the theory of finance the best we can do is to empirically try to understand it. So, yes, finding all kind of causes, effects and implications between stock markets and FDI is very possible but....it would not be related to market efficiency but rather to exploiting market inefficiencies (or things that we think are inefficiencies because we cannot explain them with our theories...)

(B)

Grossman and Stiglitz (1980) argued that because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation, leading to the conclusion that an informationally efficient market is impossible.
Sewell (2006)

"Second, perfect efficiency is an unrealistic benchmark that is unlikely to hold in practice. Even in theory, as Grossman and Stiglitz (1980) have shown, abnormal returns will exist if there are costs of gathering and processing information. These returns are necessary to compensate investors for their information-gathering and information-processing expenses, and are no longer abnormal when these expenses are properly accounted for. In a large and liquid market, information costs are likely to justify only small abnormal returns, but it is difficult to say how small, even if such costs could be measured precisely."
Campbell, Lo and MacKinlay (1997), page 24
"Grossman (1976) and Grossman and Stiglitz (1980) go even further. They argue that perfectly informationally efficient markets are an impossibility, for if markets are perfectly efficient, the return to gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the efforrt investors are willing to expend to gather and trade on information, hence a non-degenerate market equilibrium will arise only when there are sufficient profit opportunities, i.e., inefficiencies, to compensate investors for the costs of trading and information-gathering. The profits earned by these industrious investors may be viewed as economic rents that accrue to those willing to engage in such activities."
Lo and MacKinlay (1999), pages 5-6

(C) Effective capital markets is a market where the effect of capital markets are major i.e. bigger in terms of share in economic development.

To find the effectiveness of capital markets we need to find out how many companies are increasing their business using capital markets. There is no direct test available to find this.

(D) This article sets out how the capital markets relate to sustainable development issues and makes some modest proposals for how to improve our capital markets. It argues that capital markets' influence over corporate sustainable development originates via two principal routes: (i) financial influence—the buying and selling of equity shares and debt on the capital market influences the cost of capital for listed companies; and, (ii) investor advocacy influence—shareholders are the principals of the business and can exercise their rights of share ownership over their agents, the company directors, by sending explicit signals regarding the management of the company. Capital markets generally do not need to understand nor reward sustainable behaviour. This is either because the markets are inefficient and do not reward good behaviour, or because market failures means that investors do not need to worry about the very long term costs as they are outside of their investment time horizons. In order to change this, we should focus on the incentives of all key players within the capital supply chain such that they are all sanctioned and incentivized partly on their sustainability performance. The market also needs much better market information on the sustainability performance of companies. Better training of market participants on the materiality of sustainability issues as well as how they can be factored into valuation analysis would also help. However, before capital markets can be genuinely sustainable we need capital market policy makers to have greater regard for future generations when setting policy. This will require greater government intervention, particularly around the regulation of investor delivery of responsible ownership.